Sources of Business Finance Class 11 Notes

1. Finance Meaning

Finance refers to the management, creation, and study of money, investments, and other financial instruments. It involves the processes of acquiring funds and managing them effectively to achieve business objectives.

2. Finance Requirements

i) Fixed Capital Requirement

Fixed capital refers to the long-term investments in physical assets that are essential for the business’s operations. This includes purchasing property, buildings, machinery, and equipment.

Fixed capital requirements are crucial for starting a business and for long-term growth. It involves significant financial outlay and is generally less liquid, meaning these investments are not quickly convertible to cash.

ii) Working Capital Requirement

Working capital is the funds necessary for the day-to-day operations of a business. It covers short-term expenses such as inventory, accounts receivable, and other operational costs.

Adequate working capital ensures that a business can meet its short-term liabilities and continue its operations smoothly.

3. Types of Business Finance

i) On the Basis of Period

a) Short-Term Funds

Short-term funds are required for a period of up to one year. Examples include loans or credit facilities used to manage operational expenses, such as buying inventory or covering accounts payable.

b) Medium Term Funds

Medium-term funds are typically required for 1 to 5 years. They are often used for purchasing equipment or financing expansion projects. An example is a bank loan for machinery.

c) Long-Term Funds

Long-term funds are needed for periods exceeding five years, often used for significant investments such as infrastructure or large-scale projects. An example is issuing bonds for long-term capital requirements.

ii) On the Basis of Ownership

a) Owner’s Fund

Owner’s fund refers to the capital invested by the owners of the business. Types include:

• Equity Shares: Ownership shares in a company, offering dividends and voting rights.
• Retained Earnings: Profits reinvested in the business instead of being distributed as dividends.

b) Borrowed Funds

Borrowed funds are sourced from external parties and need to be repaid with interest. This includes loans from banks, debentures, and other financial instruments.

iii) On the Basis of Generation

a) Internal Sources

Internal sources refer to funds generated within the business. Types include:

• Disposing of Surplus Inventory: Selling off excess stock to generate cash.
• Retained Earnings: Using profits reinvested in the business.

b) External Sources

External sources refer to funds raised from outside the business. Types include:

• Issue of Debentures: Long-term securities yielding fixed interest.
• Borrowings from Banks: Loans taken for operational or expansion needs.
• Borrowings from Financial Institutions: Funds obtained from institutions specializing in financing.
• Public Deposits: Money collected from the public for a fixed period at a specified interest rate.

4. Retained Earnings

Retained earnings are profits that are reinvested in the business rather than distributed to shareholders.

i) Merits

1. No Interest Payment: Unlike loans, retained earnings don’t require interest payments.
2. Control Retention: Using retained earnings helps maintain control without diluting ownership.
3. Reinvestment Flexibility: Provides the business with flexibility to invest in growth opportunities.

ii) Demerits

1. Limited Capital: The amount available is dependent on past profits and may not suffice for large projects.
2. Opportunity Cost: Funds retained could be invested elsewhere for potentially higher returns.
3. Market Perception: Excessive reliance on retained earnings may signal a lack of growth opportunities to investors.

5. Trade Credit

Trade credit is a short-term financing option allowing businesses to purchase goods or services and defer payment.

i) Merits

1. Cash Flow Management: Helps manage cash flow by delaying payments.
2. No Interest Charges: Typically does not incur interest if paid within the agreed period.
3. Building Supplier Relationships: Regular use can strengthen ties with suppliers.

ii) Demerits

1. Limited Amount: Trade credit is usually limited to certain amounts and terms.
2. Potential Strain on Relationships: Late payments can damage supplier relationships.
3. Higher Prices: Suppliers may charge higher prices for credit terms.

6. Issue of Shares

i) Equity Shares

Equity shares represent ownership in a company.

Merits

1. Voting Rights: Shareholders have a say in company decisions.
2. No Repayment Obligation: Companies are not required to repay equity capital.
3. Potential for High Returns: Capital gains and dividends can be substantial.

Demerits

1. Dilution of Control: Issuing more shares can dilute existing ownership.
2. Dividend Variability: No guaranteed dividends; dependent on profits.
3. Market Fluctuations: Share prices can be volatile, affecting capital stability.

ii) Preference Shares

Preference shares provide certain privileges over equity shares, such as fixed dividends.

Merits

1. Fixed Dividend: Provides certainty with fixed dividends.
2. Priority on Assets: Preference shareholders have priority over equity shareholders in liquidation.
3. Less Risky: Generally considered safer than equity shares.

Demerits

1. No Voting Rights: Preference shareholders typically do not have voting rights.
2. Limited Upside: Capital appreciation is usually less compared to equity shares.
3. Obligation to Pay Dividends: Dividends must be paid before equity dividends.

7. Difference Between Equity and Preference Shares

International Business Class 11 Notes

8. Debentures

Debentures are long-term securities that yield fixed interest and are a form of borrowed capital.

Merits

1. Fixed Interest Rate: Provides predictable interest payments.
2. No Ownership Dilution: Issuing debentures does not affect ownership control.
3. Tax Benefits: Interest payments are tax-deductible.

Demerits

1. Repayment Obligation: Companies must repay the principal amount at maturity.
2. Interest Payment Risk: Fixed interest payments can strain cash flow during downturns.
3. Potential for Insolvency: Over-reliance on debt can lead to financial distress.

9. Difference Between Shares and Debentures

10. Lease Financing

Lease financing involves renting assets instead of purchasing them.

Merits

1. Preserves Capital: Reduces initial capital outlay.
2. Tax Benefits: Lease payments are often tax-deductible.
3. Up-to-date Equipment: Easy access to the latest technology.

Demerits

1. No Ownership: At the end of the lease, the asset is not owned.
2. Total Cost: Long-term leasing may be more expensive than buying.
3. Obligatory Payments: Lease commitments can strain cash flow.

11. Commercial Banks

Commercial banks provide a wide range of financial services including loans, deposits, and payment services.

Merits

1. Accessibility: Broad range of services available to businesses.
2. Financial Expertise: Banks offer professional financial advice.
3. Security: Funds deposited are usually insured.

Demerits

1. Stringent Conditions: Loans often come with strict eligibility criteria.
2. High Interest Rates: Borrowing costs can be significant.
3. Limited Flexibility: Rigid loan terms can restrict business operations.

12. Public Deposits

Public deposits are funds raised from the public for a specified term at a fixed interest rate.

Merits

1. Cost-Effective: Generally lower interest rates compared to bank loans.
2. Flexible Terms: Various deposit schemes to suit different needs.
3. Quick Access: Relatively easy to arrange and access funds.

Demerits

1. Reliance on Public Trust: Requires maintaining public confidence.
2. Interest Rate Risk: Must remain competitive with other investment options.
3. Limited Amount: Total funds raised can be limited.

13. Types of Debentures

Debentures are a crucial source of finance for companies and can be categorized based on different characteristics:

a) First and Second Debentures

• First Debentures: These have a priority claim over other debts in case of liquidation. They are secured by company assets, providing security to investors.
• Second Debentures: These are subordinate to first debentures and only get paid after first debentures have been settled. They usually carry a higher interest rate to compensate for increased risk.

b) Secured and Unsecured Debentures

• Secured Debentures: Backed by specific assets of the company. If the company defaults, debenture holders have a claim over the assets.
• Unsecured Debentures: Not backed by collateral. These carry higher risk, which is often reflected in the higher interest rates offered to investors.

c) Registered and Bearer Debentures

• Registered Debentures: These are recorded in the company’s register of debenture holders. The company keeps a record of ownership, which makes transferability less straightforward.
• Bearer Debentures: Not registered in any name; the holder possesses them. They can be transferred easily, making them more liquid but also riskier due to potential loss or theft.

d) Convertible and Non-Convertible Debentures

• Convertible Debentures: These can be converted into equity shares at a predetermined rate after a specific period. This offers investors potential upside if the company performs well.
• Non-Convertible Debentures: These cannot be converted into shares. They typically offer a higher fixed interest rate as a trade-off for lack of conversion benefits.

14. Types of Preference Shares

Preference shares are classified based on the rights they confer upon holders:

a) Cumulative and Non-Cumulative

• Cumulative Preference Shares: If dividends are not paid in a given year, they accumulate and must be paid in the future before any dividends are paid to equity shareholders.
• Non-Cumulative Preference Shares: These do not accumulate unpaid dividends. If a dividend is not declared, shareholders lose their right to receive it in the future.

b) Participating and Non-Participating

• Participating Preference Shares: These allow holders to receive additional dividends beyond the fixed rate if the company performs well.
• Non-Participating Preference Shares: Holders receive only the fixed dividend and do not benefit from additional profits.

c) Convertible and Non-Convertible

• Convertible Preference Shares: These can be converted into equity shares after a certain period, providing potential for capital gains.
• Non-Convertible Preference Shares: These cannot be converted into equity, providing only fixed returns without equity ownership.

15. Financial Institutions

Financial institutions play a vital role in the economy by providing various financial services, including loans, investments, and insurance.

Merits

1. Financial Intermediation: They mobilize savings from individuals and channel them into productive investments, contributing to economic growth.
2. Risk Management: They offer products like insurance and hedging options to manage risks associated with investments and operations.
3. Expertise and Advice: Financial institutions provide professional advice and management services, assisting businesses in financial planning and investment decisions.

Demerits

1. High Costs: Services provided by financial institutions can come with high fees, which may impact profitability for businesses.
2. Regulatory Constraints: They are subject to strict regulations, which can limit their flexibility and responsiveness to market changes.
3. Dependence on Economic Conditions: Their performance and ability to lend can be significantly affected by economic downturns, affecting businesses reliant on their services.

16. International Financing

International financing involves raising capital or obtaining funds from sources outside a country, and it includes several types:

a) Commercial Banks

Commercial banks provide loans and credit facilities to businesses operating internationally. They facilitate foreign trade through services like letters of credit and trade financing.

b) International Agencies & Development Banks

These organizations provide funds for development projects, often focusing on poverty alleviation, infrastructure, and social development. Examples include the World Bank and the International Monetary Fund (IMF).

c) International Capital Market

This refers to the market where international securities are traded, providing a platform for raising capital from global investors.

i) Global Depository Receipts (GDR), American Depository Receipts (ADR), and Indian Depository Receipts (IDR)

• Global Depository Receipts (GDR): These are instruments used to raise capital in foreign markets. They represent shares in a foreign company and are traded in multiple markets.
• American Depository Receipts (ADR): A type of GDR specifically for American investors. ADRs allow U.S. investors to buy shares in foreign companies without dealing with foreign stock exchanges.
• Indian Depository Receipts (IDR): Similar to ADRs but for Indian investors. IDRs allow foreign companies to raise capital in India by issuing shares through a local depository.

These instruments facilitate cross-border investments, allowing investors to diversify their portfolios internationally while offering companies access to global capital.