NCERT Solutions For Class 11 Business Studies Chapter 7 Sources of Business Finance

Commercial Paper (CP) is a source of short term finance. It is an unsecured promissory note issued by a firm to raise funds for a short period, varying from 90 days to 364 days. Generally it is issued by a business firm to another firms, insurance companies, pension funds and banks.

The amount raised by CP is generally very large. It is totally unsecured, that is why the firms having good credit rating can issue the CP. Its regulation comes under the preview of the Reserve Bank of India.

Followings are the merits of commercial paper:

• It does not create any charge on the assets of the company issuing the CP.
• It provides high liquidity and can be freely transferred.
• It provides more funds with less cost compared to other sources. The cost of issuing commercial paper is lower than the cost of commercial bank loans.
• It provides a continuous source of funds. This is because its maturity can be fixed as per the requirements of the issuing firm.
• Companies with excess funds can invest them by buying CP issued by other firm, thereby earning a good return on the same.

The following are the demerits-

• It is not possible for a new and moderately rated firms to raise funds by this method. Only financially sound and highly rated firms can raise money through commercial papers.
• There is limit to the size of money that can be raised through CP. It is limited to the excess liquidity available with the suppliers of funds at a particular time.
• The maturity period of Commercial paper is fixed and ranges from 90 to 364 days, hence if a firm is not in a position to redeem its paper due to financial difficulties, extending the maturity of a CP is not possible.

International financing means raising finances internationally. There are various sources and organisations to raise funds internationally.

Following are the financial instruments used in international financing:

Commercial Banks: Commercial banks all over the world provide foreign currency loans for business purposes. They are an important source of international financing. The types of loans and services provided by banks vary from country to country and bank to bank.

International Agencies and Development Banks: These organisations provide long and medium term loans and grants to promote the development of economically backward areas in the world. These are set up by the Governments of developed countries of the world at national, regional and international levels for funding various projects. The main organisations working internationally are International Finance Corporation (IFC), EXIM Bank and Asian Development Bank.

International Capital Markets: Modern organisations including multinational companies depend upon large borrowings in rupees and in foreign currency. For this purpose international capital markets have evolved. Main instruments used to raise funds internally in these markets are GDR, ADR and FCCB.

The financial instruments used in international Financing are:

Global Depository Receipts: GDR is an instrument issued abroad by an Indian company to raise funds in some foreign currency, which is listed and traded on a foreign exchange. Hence, these are essentially Indian shares denominated in foreign currency. The holder of GDRs do not have any voting rights but only right to dividend and capital appreciation on shares.

American Depository Receipts: It is similar to GDRs except that it is denominated in US Dollars and can be issued to American citizens only and can be listed and traded on a stock exchange of the USA. The depository receipts against shares of an Indian company issued in USA are called ADRs.

Foreign Currency Convertible Bonds: FCCBs are equity linked debt securities that are to be converted into equity receipts after a specific period. These are issued in foreign currency and carry a fixed rate of interest. They are similar to convertible debentures and they are listed and traded in foreign exchanges.

Public Deposits-The deposits that are raised by organisations directly from the public are known as public deposits. Rates of interest offered on public deposits are usually higher than that offered on bank deposits.

Merits of Public deposits are:

• The procedure of obtaining deposits is simple and does not contain restrictive conditions as are generally there in a loan agreement.
• Cost of public deposits is generally lower than the cost of borrowings from banks and financial institutions.
• 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.
• As the depositors do not have voting rights, the control of the company is not diluted.

Demerits of Public deposits are:

• New companies generally find it difficult to raise funds through public deposits.
• It is an unreliable source of finance as the public may not respond when the company needs money.
• Collection of public deposits may prove difficult, particularly when the size of deposits required is large.

Retained earnings -Business enterprise keep 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 of Retained earnings are:

• Retained earning is a permanent source of funds available to an organisation.
• It does not involve any explicit cost in the form of interest, dividend etc.
• As the funds are generated internally, there is a greater degree of operational freedom and flexibility.
• It enhances the capacity of the business to absorb unexpected losses.
• It may lead to increase in the market price of the equity shares of a company.

Demerits of Retained earnings are:

• Excessive ploughing back may cause dissatisfaction amongst the shareholders as they would get lower dividends.
• It is an uncertain source of funds as the profits of business are fluctuating.
• The opportunity cost associated with these funds is not recognised by many firms. This may lead to sub-optimal use of the funds.

The advantages which debentures provide over the issue of equity shares are as follows :

The sources from which a large industrial enterprise can raise capital for financing modernisation and expansion are as follows:

Ploughing Back of Profits: It is a good source of finance, however it depends upon the profitability of the organisation. A company generally does not distribute all its earnings amongst the shareholders as dividends. A portion of the net earnings may be retained in the business for use in the future. It is known as 'ploughing back of profits' or retained earnings. It is very cheap sources of funds since there is no explicit cost involved.

Issue of Shares: A company can issue shares to raise permanent capital. As per Indian Companies Act, 1956 a company can issue two types of shares equity shares and preference shares. The money raised by issue of equity shares is called equity share capital, while the money raised by issue of preference shares is called preference share capital. The fund raised through shares is called 'owned capital'. Shares are to be repaid only at the time of winding up of the company, when all claims of creditors are paid off. Preference shares carry fixed rate of dividend, but equity shares are piad only on basis of company's earnings. Equity shares carry voting rights.

Issue of Debentures: The debenture issued by a company is an acknowledgment that the company has borrowed a certain amount of money, which it promises to repay at a future date. These carry a fixed rate of interest which is called as coupon rate. Debenture holders are creditors of the company. Interest on debentures is paid at a fixed rate specified intervals say six months or one year. Public issue of debentures requires that the issue be rated by a credit rating agency like CRISIL (Credit Rating and Information Services of India Ltd.)

Loan from Commercial Banks or Financial Institutions: A company can raise loans from commercial banks or from non-banking financial institutions set up by the government specifically for this purpose. Commercial banks provide funds for short and medium terms, such as, cash credits, overdrafts, term loans, discounting of bills, letters of credit and term loans. The rate of interest charged by banks depends on various factors. The bank loan can be repaid either in lump sum or in installments. A company needs to provide some security before a loan is sanctioned by a commercial bank. In case a company needs loan for long term, it may be raised with other financial institutions as IDBI, SIDBI, IFCI etc. These institutions provide both owned capital and loan capital for long and medium term requirements. In addition to finance, these institutions also conduct market surveys and provide technical and managerial assistance to entrepreneurs.

Trade credit is the short term credit extended by one business to another for purchase of goods or services. It enables the purchase of goods or services without immediate payment. It is a widely used source of short term funds. Terms of credit may differ from industry to industry.

The merits of this source of funds are as follows:

• It is a convenient and continuous source of funds.
• Trade credit may be readily available in case the credit worthiness of the customers is known to the seller.
• If an organisation needs to increase its inventory level in order to meet expected rise in the sales volume in the near future, it may use trade credit.
• It does not create any charge on the assets of the firm while buying goods or services on credit.
• Trade credit needs to promote the sales of an organisation.

The demerits are as follows –

• Due to easy availability of of trade credit facilities, a firm may indulge in overtrading which may add to risk of the firm.
• Only limited amount of funds can be generated through trade credit.
• It is generally a costly source of funds as compared to other sources of raising money.
• Bank credit is not a permanent source of funds. Bank credit is a loan advanced by a bank to a business firm. The interest charged by the bank on the loan depends on the interest prevailing in the country.

Merits of bank credit as a source of short term finance are:

• Banks provide timely assistance to business by providing funds as and when needed.
• Information supplied by the consumers to the bank is kept confidential, hence there is secrecy of information.
• This is a easier source of funds as tedious formalities are not required for raining funds from banks.
• Loan from a bank is a flexible source of finance as the loan amount can be increased according to business needs and can be repaid in advance when funds are not needed.

Following are demerits of raising this type of finance:

• Funds are generally available for short periods and its extention is uncertain and difficult.
• Banks make detailed investigation of the company’s affairs, financial structure etc., and may also ask for security of assets and personal sureties. This makes the procedure of obtaining funds slightly difficult.
• Sometimes difficult terms and conditions are imposed by banks for the grant of loan. For example, restrictions may be imposed on the sale of mortgaged goods, thus making normal business working difficult.

GDR (Global Depository Receipt ) are the depository receipts denominated in US dollars issued by depository banks to which local currency shares of a company is delivered.GDR is a negotiable instrument and can be traded freely like any other security. In the Indian context, a GDR is an instrument issued abroad by an Indian Company to raise funds in some foreign currency and is listed and traded on a foreign stock exchange. The holder of GDR do not carry any voting rights but only dividends and capital appreciation.

ADR (American Depository Receipts) – 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. It is similar to GDR except that it can be issued only to American citizens and can be listed and traded on a stock exchange of USA.

Three special financial institutions and their objectives are:

Industrial Credit and Investment Corporation of India (ICICI): It assists the creation, expansion and modernisation of industrial enterprises exclusively in the private sector. The corporation has also encouraged the participation of foreign capital in the country.

Industrial Development Bank of India (IDBI): It was established in 1964 under the Industrial Development Bank of India Act, 1964 with an objective to coordinate the activities of other financial institutions including commercial banks. The bank performs three types of functions, namely, assistance to other financial institutions, direct assistance to industrial concerns, and promotion and coordination of financial-technical services.

Industrial Finance Corporation of India (IFCI): Its objectives include assisting in the balanced regional development and encouraging new entrepreneurs to enter into the priority sectors of the economy. IFCI has also contributed to the development of management education in the country.

Preference shares are those shares which carry a preference over equity shares in receiving a fixed rate of dividends and repayment of capital at the time of liquidation of company. The dividend rate on preference shares is fixed, which is paid out of net profits of a company prior to distribution of dividend on equity shares.

The preferential right enjoyed by preference shareholders are the following:

• receiving a fixed rate of dividend, out of the net profits of the company, before any dividend is declared for equity shareholders and
• receiving their capital after the claims of the company’s creditors have been settled, at the time of liquidation.

Internal sources of funds are those that are generated within a business. Accelerating collection of receivables, disposing of surplus inventories and ploughing back of profit are examples of these funds. The internal sources of funds can only fulfill limited needs of the business.

External Sources - External sources of funds includes those source that lie outside the organisation such as the suppliers, creditors, investors, banks and financial institutions. Issue of debentures, borrowing from commercial banks and financial institutions and accepting public deposits are examples of these funds. Large amount of money can be raised through external sources.

Following are the sources of raising long term finance:

• Equity shares - These are shares which get no fixed dividends and have no preference in repayment of their capital.
• Retained earnings - A company generally does not distribute all its earnings amongst the shareholders as dividends. A portion of the net earnings may be retained in the business for use in the future. It is known as 'ploughing back of profits' or retained earnings.
• Preference shares - These are shares which have preference in receiving a fixed rate of dividend, out of the net profits of the company, before any dividend is declared for equity shareholders.
• Debentures-Debenture means loan for the company which it takes from the public.
• Loans from financial institutions – Both central and state governments have established a number of financial institutions all over the country to provide industrial finance to companies engaged in business.
• Loans from Banks – Banks also provide long term finance to businesses.

Following are the sources of short term finance:

• Trade credit - Trade credit is the credit extended by supplier to purchaser, which can be dealers, for the purchase of goods and services. Trade credit facilitates the purchase of supplies without immediate payment.
• Factoring - Factoring has emerged as a popular source of short-term funds in recent years. It is a financial service whereby the factor is responsible for all credit control and debt collection from the buyer and provides protection against any bad-debt losses to the firm.
• Banks – Business enterprise can obtain short term finance from banks.
• Commercial paper – These are credit instrument used by creditworthy firms to obtain short term finance for their business.

Business finance refers to the funds required to carry out the establishment and running operation of a business. The business needs finance for fixed capital requirement and working capital requirement.

• Fixed capital requirement - A business organisation needs funds to purchase fixed assets like land and building, plant and machinery, furniture and fixtures, etc. The funds needed for this purpose, are called fixed capital requirements of the business. These funds remain invested in the business for a long period of time. That is why it is better to finance such requirement through long term sources. Different business organisations need varying amount of fixed capital depending on the nature of business. For example, a trading concern requires small amount of fixed capital as compared to a manufacturing concern.
• Working capital requirement -Every organisation whether small or large it needs funds for its day-to-day operations. The funds needed for day-to-day operations is called working capital. It is used to maintain current assets such as stock of material, bills receivables and to meet current expenses like salaries, wages, taxes, rent, etc. The amount of working capital required varies from one organisation to another depending on its nature. For example a business unit selling goods on credit, or having a slow sales turnover would require more working capital as compared to another unit selling its goods and services on cash basis or having a speedier turnover. Moreover, a trader would require a higher working capital than a manufacturer.

d) generated within the business.

Explanation:

Internal sources of capital are those that are generated from with the business. For example, a business can generate funds internally by accelarating collection of receivables, disposing of surplus inventory and ploughing back its profit.

d) 90 to 364 days.

Explanation:

Commercial paper is an unsecured promissory note issued by a firm to raise funds for a short period. The maturity period of commercial paper usually ranges from 90 days to 364 days. It represents a new financial instrument issued for the purpose of working capital.

c) collects the client’s debt or account receivables.

Explanation:

Under the factoring arrangement, the factor collects the client’s debt or account receivables. Factoring refers to an arrangement under which financial service providers known as ‘factors’ agree to provide certain types of services to business owners.

d) Loan capital of the company.

Explanation:

Debenture means loan for the company which it takes from the public.

c) Use the asset for a specified period.

Explanation:

Under the lease agreement, the lessee gets the right to use the asset for a specified period. In other words, a lease agreement is an agreement between two parties by which the owner of the asset grants the right to another party to use it in return for a periodic payment.

a) The public.

Explanation:

A company can raise funds by inviting the public to deposit their savings with their company. Public deposits may take care of both short term and long term financial requirements of business.

d) USA.

Explanation:

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) Working capital requirement.

Explanation:

Current assets are used for the day to day operations of a business such as purchase of raw materials, payment of wages, salaries etc.

a) Preference shares.

Explanation:

The term redeemable is used for preference shares. It implies the amount of preference shares which is repaid by a company after a certain specified period of time.

a) owners of the company.

Explanation:

Equity shareholders are called the owners of the company. The dividends that they receive are the part of profits which is left after making or settling all other claims of the country.