Sources of
Business Finance
Finance is the lifeblood of business. From equity shares and retained earnings to debentures, bank loans and trade credit — this chapter covers every source of funds a business can tap. Master the difference between owned and borrowed capital, and you master this chapter.
Every Business Runs on Two Pockets: Own Money and Borrowed Money
A business needs money to buy land, build factories, buy raw materials and pay wages. This money comes from two places: money the owners themselves bring in (owned capital) and money they borrow from others (borrowed capital). Choosing the right mix of the two — the capital structure — is one of the most important financial decisions in business. Too much borrowing creates risk; too little limits growth.
1. Concept, Nature and Importance of Business Finance
What is Business Finance?
Business finance refers to the money required by a business for carrying out its various activities — setting up, running, expanding and meeting emergencies. It is called the lifeblood of business because just as blood is essential for a living body, finance is essential at every stage of business life.
1.1 Need and Importance of Business Finance
Fixed Capital Needs
To buy or build long-term assets — land, factory buildings, machinery, vehicles and furniture — that are used for years. These require large upfront investment before any production begins.
Working Capital Needs
Day-to-day operational expenses — buying raw materials, paying wages, utility bills, rent, advertising — that recur regularly. A shortage of working capital can stop even a profitable business in its tracks.
Growth and Expansion
Opening new branches, launching new products, entering new markets, acquiring other companies — all require fresh capital beyond what internal profits can provide.
Meeting Contingencies
Unexpected events — fire, flood, economic downturn, sudden competitor pricing — require emergency funds. A business without a financial buffer is dangerously fragile.
Modernisation and Technology Upgradation
Old machinery must be replaced, newer technology adopted and production processes upgraded to remain competitive. This requires periodic large capital outlays.
2. Owners' Funds (Owned Capital)
Owners' funds are the funds contributed by the owners — proprietors, partners or shareholders — and the profits retained within the business. The key characteristic is that there is no fixed obligation to pay interest or repay the principal. It is also called equity or net worth.
2A. Equity Shares (Ordinary Shares)
Equity shares represent the basic ownership unit of a company. Equity shareholders are the real owners of the company. They bear the highest risk but also enjoy the highest reward if the company performs well.
Ownership and Voting Rights
Equity shareholders own the company and exercise control through voting in Annual General Meetings. They elect the Board of Directors.
Residual Dividend
Dividend on equity shares is paid AFTER paying dividends to preference shareholders and meeting all other obligations. If profits are high, the dividend can be very generous; if profits are low, no dividend need be paid.
No Fixed Rate of Dividend
The dividend rate is decided by the Board each year based on profits available. There is no fixed obligation, which protects the company during lean years.
Permanent Capital
Equity capital is not repaid during the lifetime of the company. It forms the permanent, stable foundation of the capital structure.
Maximum Risk, Maximum Reward
In case of winding up, equity shareholders are paid last — after all creditors and preference shareholders. Their risk is highest. But when the company prospers, their returns are unlimited.
| Merits of Equity Shares | Limitations of Equity Shares |
|---|---|
| No fixed dividend obligation — protects company in loss years | Dividend is paid from after-tax profit — no tax benefit |
| Permanent capital — no repayment during company life | Issuing more equity dilutes the control of existing owners |
| Strengthens credit standing — more equity allows more safe borrowing | Floatation costs (issue expenses) are high |
| Voting rights motivate shareholders to monitor management | Returns are uncertain — unattractive to risk-averse investors |
2B. Preference Shares
Preference shares have a preferential right over equity shares in two ways: (i) receiving dividend at a fixed rate before any equity dividend is paid, and (ii) repayment of capital before equity shareholders on winding up of the company.
Cumulative vs Non-Cumulative
Cumulative: If dividend is not paid in one year due to low profits, the arrears accumulate and must be paid in future profitable years before any equity dividend. Non-cumulative: Unpaid dividend lapses; no right to arrears.
Redeemable vs Irredeemable
Redeemable: The company repays the capital to preference shareholders after a specified period (most preference shares today are redeemable). Irredeemable: Capital is never repaid during the company's lifetime (now rarely issued).
Participating vs Non-Participating
Participating: After receiving their fixed dividend, participating preference shareholders share the surplus profit with equity shareholders. Non-participating: Entitled only to the fixed rate dividend.
Convertible vs Non-Convertible
Convertible: Can be converted into equity shares after a specified period at the option of the holder. Non-convertible: Cannot be converted; remain as preference shares throughout.
| Merits of Preference Shares | Limitations of Preference Shares |
|---|---|
| Fixed dividend — predictable return for investors | Fixed dividend is an obligation even in low-profit years |
| Generally no voting rights — control is not diluted | Dividend paid from after-tax profit — no tax shield |
| Safer than equity for investors — priority in dividend and repayment | Cost is higher than debt because dividend is not tax-deductible |
| Suitable for risk-averse investors who want regular income | Cumulative preference dividend can become a heavy burden over years |
2C. Retained Earnings (Ploughing Back of Profits)
When a company earns profit, it has two choices: distribute it to shareholders as dividend, or keep it within the business for future use. The profit kept within the business is called retained earnings, reserves and surplus, or ploughing back of profits. This is the simplest and most cost-free source of finance.
| Merits of Retained Earnings | Limitations of Retained Earnings |
|---|---|
| No cost — no interest, no dividend obligation on retained funds | Shareholders lose current dividend income — may lead to dissatisfaction |
| No dilution of ownership — existing shareholders retain full control | Depends entirely on profitability — not available to loss-making companies |
| No floatation cost — no issue expenses unlike shares or debentures | Excessive retention can lead to overvaluation of shares |
| No legal formalities — no prospectus, no SEBI filings required | May encourage complacency in management — easy money with no accountability |
| Permanent internal source — strengthens the financial base | Not a substitute for external finance when large capital is needed rapidly |
3. Borrowed Funds (Loan Capital)
Borrowed funds are funds obtained from external sources other than the owners. They carry a fixed obligation to pay interest and repay the principal within a specified time. The major advantage is that interest is a tax-deductible expense — it reduces the taxable profit of the company.
3A. Debentures and Bonds
What is a Debenture?
A debenture is a written acknowledgement of a debt taken by a company. It is a certificate issued under the common seal of the company acknowledging that the company has borrowed a specified sum at a specified rate of interest for a specified period. Debenture holders are creditors of the company — NOT owners. They have no voting rights but their interest is paid before any dividend.
Secured vs Unsecured
Secured (Mortgage) Debentures: Backed by a charge on the assets of the company. In case of default, debenture holders can sell those assets to recover their money. Unsecured (Naked) Debentures: No asset backing — higher risk for investors.
Redeemable vs Irredeemable
Redeemable: Repaid at the end of the specified term. Irredeemable (Perpetual): Never repaid during the life of the company; interest is paid indefinitely.
Convertible vs Non-Convertible
Fully Convertible (FCD): Converted into equity shares after a period. Partly Convertible (PCD): Part is converted into equity, rest redeemed. Non-Convertible (NCD): Redeemed in cash; no conversion.
Registered vs Bearer
Registered: Name of holder recorded in company register; transfer requires formality. Bearer: Transferred by mere delivery — whoever holds it gets interest.
Bonds are similar to debentures but are typically issued by governments, public bodies or large financial institutions. Government Securities (G-Secs) and RBI Bonds are examples. They are generally considered safer than corporate debentures.
| Merits of Debentures | Limitations of Debentures |
|---|---|
| Interest is a charge on profit — tax-deductible, reducing the effective cost | Fixed interest must be paid even in loss years — creates financial risk |
| No dilution of ownership — debenture holders have no voting rights | Creates a long-term fixed liability on the balance sheet |
| Suitable for companies with stable earnings and assets to offer as security | Unsuitable for new companies with uncertain cash flows and limited assets |
| Fixed return attracts a large pool of risk-averse investors | Legal formalities of creating a charge on assets can be complex and costly |
3B. Loans from Financial Institutions
India has a network of Development Finance Institutions (DFIs) set up by the government specifically to finance industrial growth. They provide medium and long-term loans for setting up new industries, expansion and modernisation. Key institutions: IDBI (Industrial Development Bank of India), IFCI (Industrial Finance Corporation of India), SIDBI (Small Industries Development Bank of India), NHB (National Housing Bank), NABARD (for agriculture and rural development).
| Merits | Limitations |
|---|---|
| Long repayment period — suitable for setting up large industrial projects | Lengthy application and sanction procedures — not suitable for urgent needs |
| Interest rates may be concessional for priority sector borrowers | Strict conditions and covenants restrict management freedom |
| Also provide technical and managerial expertise along with funds | Require substantial collateral and detailed project reports |
3C. Loans from Commercial Banks
Commercial banks (SBI, HDFC Bank, ICICI Bank, Punjab National Bank, etc.) are the most commonly used source of external finance, especially for small and medium enterprises (SMEs). They provide short-term and medium-term finance through multiple forms.
Term Loan
A fixed lump-sum loan repaid in instalments (EMIs) over a specified period. Used for purchasing machinery, vehicles or equipment. Interest is charged on the outstanding balance.
Overdraft / Cash Credit
Flexible credit up to a pre-approved limit on the current account (already studied in Chapter 4). Interest charged only on amount used. Ideal for working capital needs.
Discounting of Bills
The bank buys a trade bill (bill of exchange) from the seller before its due date at a discount and collects the full amount from the buyer on the due date. The seller gets immediate cash; the bank earns the discount as its income.
Letter of Credit
A bank guarantee to the seller that the buyer will pay. Widely used in international trade to give the exporter confidence that payment will be made by the bank if the buyer defaults.
3D. Public Deposits
Companies invite the general public to deposit money directly with the company for a fixed period at a fixed interest rate higher than bank deposits. Governed by the Companies Act. Period: 6 months to 36 months (3 years). This is a very economical source of medium-term finance.
| Merits of Public Deposits | Limitations of Public Deposits |
|---|---|
| Simple procedure — no elaborate legal formalities or asset charges | Uncertain source — depositors may not renew on maturity; sudden demand for repayment is possible |
| Cheaper than debentures — no trustee fees, no asset registration charges | Not suitable for long-term capital needs — maximum 3 years |
| No dilution of control — depositors have no voting rights | Available mainly to well-known, creditworthy companies; new companies struggle to attract deposits |
| Interest is tax-deductible — same tax benefit as debentures | Risky for depositors as they are unsecured (no asset backing) |
3E. Trade Credit
Trade credit is the credit extended by one business to another for the purchase of goods or services. When a retailer buys goods from a wholesaler and is allowed to pay in 30, 60 or 90 days, that is trade credit. It is the most natural and widely used form of short-term finance — it arises automatically in the course of business.
| Merits of Trade Credit | Limitations of Trade Credit |
|---|---|
| Easy and automatic — available without formal application | Restricted to purchase of goods only — cannot be used for wages or other expenses |
| Generally no interest — seller benefits from a long-term business relationship | Amount is limited by the creditworthiness of the buyer |
| Flexible — credit period can be negotiated based on relationship | Losing trade credit (due to late payment) can disrupt the supply chain |
| Builds business relationships and trust in the supply chain | Short-term only — cannot substitute for long-term capital |
3F. Inter Corporate Deposits (ICD)
Inter Corporate Deposits are short-term deposits made by one company with another company in the money market, for a period usually ranging from a few days to 6 months, at a mutually agreed interest rate that is generally higher than bank rates. It is a transaction in the inter-company money market — a large company with surplus cash lends to another company that needs short-term funds.
| Merits of ICD | Limitations of ICD |
|---|---|
| Quick and flexible — no lengthy formalities; funds available at short notice | High risk — generally unsecured; if the borrowing company defaults, recovery is difficult |
| Higher interest rate for the lending company than bank deposits | Short-term only — cannot meet long-term or even medium-term capital needs |
| Helps companies deploy short-term surplus cash productively | Available only between large, well-established companies — not accessible to SMEs |
4. Owners' Funds vs Borrowed Funds: Master Comparison
| Basis | Owners' Funds | Borrowed Funds |
|---|---|---|
| Meaning | Funds contributed by owners / shareholders plus retained profits | Funds obtained from outside lenders (banks, debenture holders, depositors) |
| Obligation to repay | No — permanent capital (except redeemable preference shares) | Yes — must be repaid within agreed time |
| Return | Dividend — paid only if profit exists; no fixed rate for equity | Interest — must be paid regardless of profit or loss |
| Tax benefit | No — dividend is paid from after-tax profit | Yes — interest is a tax-deductible expense, reducing tax liability |
| Risk to provider | High — last claim in case of winding up | Low — lenders have prior claim over assets |
| Control | Equity holders have voting rights; control may dilute | Lenders have no voting rights; management control is not affected |
| Security | Not required | Often required — mortgage of assets, guarantees |
| Suitability | Long-term permanent needs; new companies | Short, medium and long-term needs; established companies with stable earnings |
| Examples | Equity shares, preference shares, retained earnings | Debentures, bank loans, public deposits, trade credit, ICD, financial institution loans |
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20 MCQs — Sources of Business Finance
Owners' funds, borrowed funds and the key differences between them — mixed difficulty with CUET-level Assertion-Reason and application questions in Q17–Q20.
Reason (R): Debenture holders are creditors of the company, and interest on debt is treated as a charge on profit — not an appropriation of profit.
Reason (R): Retained earnings are generated internally from the profits of the company and do not require issuing any new shares to outside investors.
Chapter 7 — Live Quiz
20 questions · Sources of Business Finance · One at a time · Instant feedback
