FINANCE & BANKING 21BSO662

Module-5: Sources of finance

Methods of rising finance- Equity and preference shares, Debentures, and bonds, retained
earnings, public deposits, loan from commercial banks, financial institutions, trade credits.

Business is concerned with the production and distribution of goods and services to meet
demands. Finance is required by businesses to carry out many activities. As a result, finance is
said to as the “vital blood” of any business. Business finance refers to a company’s need for
finances to carry out its numerous operations. Different sources of finance include Retained
Earnings, Trade Credit, Factoring. Lease Financing, Public Deposits, Debentures, etc.

Sources of Finance

A company can raise capital from a variety of sources. Each source has distinct features that
must be properly analysed in order to choose the greatest accessible method of obtaining
finances. For all organisations, there is no one optimum source of funding. A choice of the
source to be used may be made depending on the situation, purpose, cost, and associated risk.

Finance is required at the point when an entrepreneur decides to launch a business. For
example, funds are needed to buy furniture, equipment, and other fixed assets. Similar to this,
funds are needed for regular operations, such as buying supplies or paying employees’ salaries.
Additionally, a business needs funds to expand. For Example, if a company wants to raise funds
to fulfil its fixed capital requirements, long-term finances may be necessary, which can be
raised through either owned or borrowed funds. Similarly, if the goal is to meet the day-to-day
needs of the business, short-term sources may be utilized.

Without sufficient funding, a business is unable to operate. The entrepreneur’s initial

investment may not always be enough to take care of the company’s entire financial needs. As
a result, a businessman needs to look for various other sources where the need for funds can be
satisfied. Running a business organisation, therefore, requires a clear understanding of the
financial requirements and the identification of various sources of funding.

Classification of Sources of Funds

Businesses can raise capital through various sources of funds which are classified into three
categories.
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1. Based on Period – The period basis is further divided into three dub-division.

• Long Term Source of Finance – This long term fund is utilized for more than five
years. The fund is arranged through preference and equity shares and debentures etc.
and is accumulated from the capital market.
• Medium Term Source of Finance – These are short term funds that last more than one
year but less than five years. The source includes borrowings from a public deposit,
commercial banks, commercial paper, loans from a financial institute, and lease
financing, etc.
• Short Term Source of Finance – These are funds just required for a year. Working
Capital Loans from Commercial bank and trade credit etc. are a few examples of these
sources.

2. Based on Ownership – These sources of finance are divided into two categories.

• Owner’s Fund – This fund is financed by the company owners, also known as owner’s
capital. The capital is raised by issuing preference shares, retained earnings, equity
shares, etc. These are for long term capital funds which form a base for owners to obtain
their right to control the firm’s management and operations.

• Burrowed Funds – These are the funds accumulated with the help of borrowings or
loans for a particular period of time. This source of fund is the most common and
popular amongst the businesses. For example, loans from commercial banks and other
financial institutions.

3. Based on Generation – This source of income is categorized into two divisions.

• Internal Sources – The owners generated the funds within the organization. The
example for this reference includes selling off assets and retained earnings, etc.

• External Source – The fund is arranged from outside the business. For instance,
issuance of equity shares to public, debentures, commercial banks loan, etc.

Methods of Raising Finance

Raising finance is a critical function for any business enterprise, as funds are needed for
establishing, operating, and expanding business activities. The method of raising finance
depends on the type of business, the purpose of the funds, duration, cost of capital, and the
associated risk.
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Finance can be raised through two primary sources:

• Internal Sources (within the organization)

• External Sources (outside the organization)

I. Internal Methods of Raising Finance

1. Retained Earnings (Ploughing Back of Profits)

Retained earnings refer to the portion of net profits that is not distributed as dividends but
reinvested in the business.

Features:

• No additional cost of capital.

• Indicates sound financial management.

• Strengthens reserves and surplus.

Advantages:

• No dilution of ownership.

• Enhances self-financing ability.

• Improves creditworthiness.

• Provides flexibility in financial planning.

Disadvantages:

• Limited to the amount of profit earned.

• May lead to overcapitalization.

• Dissatisfaction among shareholders if dividend payouts are consistently low.

II. External Methods of Raising Finance

A. Ownership Capital (Equity Capital)

2. Equity Shares

Equity shares represent ownership in a company. Shareholders have voting rights and a residual
claim on income and assets.
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Features:

• Permanent capital.

• High-risk, high-return instrument.

• No obligation to pay dividends.

Advantages:

• No repayment obligation.

• Provides long-term capital.

• Enhances company’s net worth.

Disadvantages:

• Dilution of control and ownership.

• Dividend is not tax-deductible.

• Higher flotation cost than debt.

3. Preference Shares

Preference shareholders have preferential rights over equity shareholders in terms of dividend
payment and capital repayment.

Types:

• Cumulative and Non-Cumulative

• Redeemable and Irredeemable

• Participating and Non-Participating

• Convertible and Non-Convertible

Advantages:

• Fixed dividend reduces uncertainty.

• No dilution of control (in most cases).

• Useful for projects with predictable cash flows.

Disadvantages:
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• Dividend is not tax-deductible.

• Fixed financial burden even in loss-making years (for cumulative preference).

• Less attractive to investors compared to equity shares due to lack of voting rights.

4. Debentures and Bonds

Debentures are long-term debt instruments issued by companies to borrow money at a fixed
interest rate. Bonds are similar instruments issued in capital markets.

Types:

• Convertible vs. Non-convertible

• Secured vs. Unsecured

• Registered vs. Bearer

• Redeemable vs. Irredeemable

Advantages:

• Interest is tax-deductible (reduces effective cost).

• No dilution of ownership.

• Helps in financial leverage.

Disadvantages:

• Fixed interest payment is mandatory.

• Increases financial risk.

• Must be repaid on maturity.

5. Public Deposits

Public deposits are unsecured deposits invited by companies from the public for a fixed term
at a specified interest rate.

Regulations:

• Governed by Companies Act and SEBI/RBI guidelines.

• Typically used for working capital requirements.

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Advantages:

• Simpler and less costly than bank loans.

• No dilution of control.

• Flexibility in terms and repayment.

Disadvantages:

• Limited amount and duration.

• High default risk perception.

• Heavily regulated and less preferred post regulatory tightening.

6. Loans from Commercial Banks

Commercial banks provide various types of loans for both short-term and long-term needs.

Types of Bank Loans:

• Term loans

• Overdraft facility

• Cash credit

• Bill discounting

Advantages:

• Quick access to funds.

• Flexibility in borrowing options.

• Relationship with banks can benefit credit rating.

Disadvantages:

• Requires collateral/security.

• Interest cost regardless of business performance.

• Strict terms and monitoring.

7. Loans from Financial Institutions

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Financial institutions like IFCI, IDBI, SIDBI, EXIM Bank, NABARD, etc., offer medium- to
long-term project loans.

Characteristics:

• Suitable for large industrial projects.

• May offer concessional rates or sector-specific loans.

• Often come with technical and advisory support.

Advantages:

• Longer tenure and larger amounts than commercial banks.

• Often includes a moratorium on repayment.

• Supportive of new or high-risk projects.

Disadvantages:

• Complex application process.

• High level of scrutiny and compliance.

• Less flexible than bank loans.

8. Trade Credit

Trade credit is a short-term credit extended by suppliers for purchasing goods/services without
immediate payment.

Features:

• Usually interest-free for a specific credit period.

• Helps in managing working capital.

Advantages:

• Easy to obtain and no formal process.

• Enhances liquidity.

• Builds business relationships.

Disadvantages:
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• May strain supplier relations if payments are delayed.

• Over-dependence can affect negotiation power.

• May include hidden costs like loss of cash discounts.

Loan Procedure from Commercial Banks

The process of getting a loan from a commercial bank involves several well-defined steps.
Banks follow strict due diligence and credit appraisal norms to ensure borrower credibility and
repayment capacity.

Step 1: Assessing Credit Needs

Before approaching the bank, the borrower (individual/business) must:

• Evaluate the purpose of the loan (working capital, term loan, etc.).

• Determine the amount of finance needed.

• Decide on the desired tenure and repayment schedule.

Step 2: Selecting the Right Bank and Loan Product

The borrower should:

• Compare loan products, interest rates, repayment terms, and services offered by
different banks.

• Choose between secured (collateral-based) or unsecured (no-collateral) loans.

• Select the type of loan (e.g., term loan, cash credit, overdraft, bill discounting).

Step 3: Application for Loan

The borrower must fill out the loan application form, which typically requires the following:

• Personal details (for individuals) or company details (for businesses).

• Purpose and amount of loan.

• Proposed security or collateral.

• Bank account and credit history.

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Step 4: Submission of Documents

The borrower is required to submit relevant documents for verification. These include:

For Individuals:

• KYC documents (ID proof, address proof)

• Income proof (salary slips, ITRs, bank statements)

• Employment proof

For Businesses:

• Business registration certificates

• Partnership deed/Memorandum and Articles of Association (MOA & AOA)

• Audited financial statements (Balance Sheet, P&L) for the last 2–3 years

• Income Tax Returns and GST returns

• Business plan or project report (for term loans)

• Details of existing loans or liabilities

• Collateral documents (if any)

Step 5: Credit Appraisal by Bank

The bank’s credit team evaluates:

• Creditworthiness of the borrower

• Repayment capacity, based on income/cash flow

• Debt-to-income ratio or debt-service coverage ratio (DSCR)

• Security coverage (collateral vs. loan value)

• Credit score (CIBIL or other agency report)

They may also conduct personal interviews or field visits.

Step 6: Sanctioning of Loan

If the loan is approved, the bank:

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• Issues a Sanction Letter mentioning the amount, interest rate, tenure, EMI, security, and
covenants.

• May negotiate terms before final approval.

• Takes internal credit committee approval (for large loans).

Step 7: Loan Agreement and Documentation

After approval:

• The borrower signs the loan agreement and other legal documents.

• Stamp duty may be applicable based on state laws.

• Post-dated cheques or ECS mandate is collected for EMI repayments.

Step 8: Disbursement of Loan

After documentation, the bank:

• Disburses the loan amount in lump sum (term loan) or opens a cash credit/overdraft
account for working capital.

• May disburse the amount directly to suppliers in case of project finance.

Step 9: Post-Disbursement Monitoring

• Regular monitoring of repayment performance.

• Periodic submission of stock statements, financials, or utilization reports (for

businesses).

• Site inspection or audits, especially for project-based loans.

II. Loan Procedure from Financial Institutions (like SIDBI, IDBI, IFCI, NABARD, EXIM
Bank)

The procedure is similar to commercial banks but more formalized and rigorous, especially for
large industrial or infrastructure loans.

Step 1: Loan Application

The borrower must submit a detailed application along with:

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• Project profile

• Nature and scope of business

• Details of promoters and management

• Financial projections (CMA data for at least 5–7 years)

• Sources and uses of funds

Step 2: Preparation of Detailed Project Report (DPR)

The DPR includes:

• Project description and feasibility

• Market and technical analysis

• Estimated costs and financing structure

• Environmental and social impact (if applicable)

• Expected revenues and repayment schedule

Step 3: Technical and Financial Appraisal

The financial institution conducts:

• Technical appraisal – Feasibility, machinery, technology used

• Economic appraisal – Demand-supply analysis, market potential

• Financial appraisal – IRR, NPV, DSCR, payback period, break-even analysis

They may consult external experts for specialized evaluations.

Step 4: Site Inspection and Due Diligence

• Team visits project site to verify infrastructure, capacity, and promoter background.

• Legal verification of assets pledged as collateral.

Step 5: Sanctioning of Loan

• A sanction letter is issued after approval by the institution’s credit or investment

committee.
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• Terms of assistance, such as interest rate, repayment schedule, moratorium, and

security, are clearly mentioned.

Step 6: Execution of Legal Documents

The borrower signs:

• Loan agreement

• Mortgage or hypothecation deed

• Guarantee documents (if applicable)

Step 7: Disbursement of Funds

Funds are released:

• As per the project’s progress (milestone-based disbursement).

• After submission of invoices or proof of expenditure.

• Directly to vendors in many cases.

Step 8: Monitoring and Reporting

The borrower must:

• Submit periodic progress and financial reports.

• Undergo inspections and audits.

• Maintain escrow or designated accounts for repayments (for large projects).

Comparison: Bank vs. Financial Institutions

Criteria Commercial Banks Financial Institutions

Loan Size Small to medium Medium to large

Speed of Processing Faster Slower (due to detailed appraisal)

Appraisal Credit-focused Technical + Financial + Economic

Repayment Terms Short to medium-term Medium to long-term

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Criteria Commercial Banks Financial Institutions

Monitoring Moderate Intensive

Support Services Limited Advisory and technical support

Equity Shares: Merits and Demerits

A company’s most important source of long-term capital is equity shares. Because equity shares
represent a company’s ownership, the capital raised through the issuance of such shares is
known as ownership capital or owner’s funds. A company must have equity share capital in
order to be established. Equity shareholders are paid on the basis of the company’s earnings
rather than a fixed dividend. They are known as residual owners since they receive what
remains after all other claims on the company’s income and assets have been satisfied. They
gain from the reward while also bearing the risk of ownership. Their liability is limited to the
amount of capital they invested in the company.

• When an investor holds equity shares in a company, they become partial owners of that
company.

• Equity shareholders may receive a share of the company’s profits in the form of
dividends.

• Equity shares are considered riskier compared to other financial instruments, such as
bonds.

Features of Equity Shares

1. Primary Risk Bearers: The equity shareholders of a company are its primary risk
bearers. It means that if the company faces a loss, then its shareholders will have to bear
the loss. Also, before paying the equity shareholders their due payment, it is first given
to the company’s creditors.
2. Basis for Loans: A company can raise loans based on its equity share capital. The
amount of equity share capital adds up to the credibility of the company and thus increases
the confidence of the creditors.
3. Claim over Residual Income: The equity shareholders of a company have a claim
over its leftover income only. It means that, after satisfying all the claims of every
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creditor, outsider, and preference shareholder, if the company is still left with income, the
equity shareholders can claim that money.
4. Higher Profit: The rate of interest of debenture holders and the rate of dividend for
preference shareholders are fixed; however, there is no fixed rate for equity shareholders.
Therefore, in the case of profit, the debenture holders and preference shareholders will
get the fixed income only; however, the equity shareholders will enjoy a higher profit.
5. Control: The equity shareholders have control over the activities of a company. They
have voting rights and thus can case vote for the selection of the Board of Directors. The
Board of Directors are those who control and manage the company’s affairs.
6. Pre-emptive Rights: The provisions of Companies Act gives Pre-emptive rights to the
shareholders. This right states that, whenever a company plans to issue new equity shares,
first of all, it must offer the shares to its existing shareholders. If they refuse to buy the
new shares, then only the company shall offer the shares to the general public. By doing
this, the right protects the equity shareholder’s controlling rights.
7. Permanent Capital: The equity shareholders of a company provide it with permanent
funds. The company does not commit to return the money or pay dividends at a fixed
rate.
Merits of Equity Shares
• Ideal for Adventurous Investors: Equity shares are appropriate for investors who
are willing to take on risk in exchange for higher returns.
• No Obligation to give Dividends: The payment of dividends to equity shareholders
is optional. As a result, the company bears no burden in this regard.
• Source of Fixed Capital: Equity capital is permanent capital because it is repaid
only when a company is liquidated. It provides a buffer for creditors in the event of a
company’s insolvency because it is listed last on the list of claims.
• Provides Credit Standing: Equity capital provides the company with
creditworthiness and confidence in potential loan providers.
• No Charge on Assets: Funds can be raised through an equity issue without placing
a charge on the company’s current assets. If necessary, a company may freely
mortgage its assets in exchange to obtain financing.
• Democratic Management: The voting rights of equity shareholders ensure
democratic control over the company’s management.
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Demerits of Equity Shares

1. Risk of Fluctuating Returns: Due to the fluctuating returns on equity shares,
investors looking to find a consistent income may not prefer equity shares.
2. High Cost of Capital: The cost of equity shares is typically higher than the cost of
raising funds from other sources.
3. Dilution of Control: The voting rights and profits of current equity shareholders are
diluted when new equity shares are issued.
4. Legal Formalities: Raising money through the issuance of equity shares involves
more formalities and delays in the legal process.
5. Danger of Over-capitalisation: Equity share capital is a permanent source of capital.
So, if due to poor financial planning, a company raises excess equity capital, it may get
over-capitalised and the equity capital may remain underutilised and idle.

Preference Shares : Features, Types, Merits and Demerits

Preference shares are those shares that are issued with features like preferential claim to
dividends and capital repayment with a fixed rate of return. Preference share capital is the
capital acquired through the issuance of preferred shares. There are two ways in which
preference shareholders are in a better position than equity shareholders:

1. Receiving a fixed rate of dividend before any dividend is paid to equity shareholders
out of the company’s net profits.

2. Receiving their capital at the time of the company’s liquidation after the debts of its
creditors have been settled.

In comparison to equity shareholders, preference shareholders have a preferential claim to

dividends and capital repayment. Preference shares are similar to debentures in that they have
a fixed rate of return. Furthermore, As the dividend is paid only at the discretion of the directors
and only from profit after tax, these are similar to equity shares in that context. As a result,
preference shares share some characteristics of both equity and debentures.

Features of Preference Shares

1. Fixed Rate of Dividend: Preference shareholders get dividends before equity shareholders
at a fixed rate.
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2. No Security: The preference shareholders do not get any security from the company against
their shares. Besides, preference share capital is a part of the owner’s fund capital of the
company.

3. Hybrid Security: As preference shares consist of the features of both equity shares
and debentures, they are known as Hybrid Securities. Just like equity shares, the preference
shareholders get dividends only when the company earns a profit, and just like debentures,
preference shareholders get a fixed rate of return.

4. Voting Rights: Under general conditions, the preference shareholders do not have voting
rights. However, if the dividends are not paid for two years or more, the preference shareholders
get voting rights.

5. Help to Collect Large Amount of Funds: As cautious investors and financial

institutions prefer to invest in preference shares of a company, it helps them collect a huge
amount of funds. Besides, preference shares attract more public because of their fixed rate of
return.

6. No Fixed Liability: Preference shareholders get dividend only when the company earns
profit. Therefore, in case of losses, the company is not obliged to pay dividend to the preference
shareholders.

Types of Preference Shares

Preference Shares are of the following types:

1. Cumulative Preference Shares: Cumulative Preference Shares are those that have
the right to accumulate unpaid dividends in future years if they are not paid during the
current year.

2. Non-Cumulative Preference Shares: Non-cumulative Preference Shares are those

on which dividends do not accumulate. It means that if a company does not declare
dividends for any year, the right of dividend of such shareholders for that year will be
lost.

3. Participating Preference Shares: Participating preference shares are preference

shares that have the right to participate in the additional surplus of a company’s shares
after a dividend at a certain rate has been paid on equity shares.
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4. Non-Participating Preference Shares: Non-participating preferences are those

who do not have the right to participate in the company’s profits.

5. Convertible Preference Shares: Convertible preference shares are preference

shares that can be converted into equity shares within a certain time frame.

6. Non-Convertible Preference Shares: Non-convertible shares are those that cannot

be converted into equity shares.

Merits of Preference Shares

The merits of raising funds through preference shares are:

1. Consistent Income: Preference shares provide reasonably consistent income in the

form of a fixed rate of return and investment safety.

2. Reasonable Safety of Returns: Preference shares are useful for investors seeking a
fixed rate of return with low risk.

3. No Interference in Management: It has no effect on equity shareholders’ control

over management because preference shareholders do not have voting rights.

4. Trading on Equity: Paying a fixed dividend rate to preference shares may enable a
company to declare higher dividend rates to equity shareholders in good times.

5. Repayment of Principal Amount: In the event of a company’s liquidation,

preference shareholders have a preferential repayment right over equity shareholders.

6. No Charge on Assets: Preference capital does not impose any kind of charge on a
company’s assets.

Demerits of Preference Share

The demerits of raising funds through preference shares are:

1. Limits Appeal: Preference shares are not suitable for investors who are willing to
take risks in exchange for higher returns.

2. Dilutes Claim of Equity Shareholders: Preference capital dilutes equity

shareholders’ claims towards the company’s assets.
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3. Unreliable and Low Returns: As the dividend on these shares is only paid when
the company makes a profit, there is no guaranteed return for investors. As a result,
these shares may not be very appealing to investors.

4. No Tax Benefits: The dividend is not deductible as an expense from profits. As a

result, there is no tax savings, as in the case of interest on loans.

Debenture : Meaning, Types, Advantages, and Disadvantages

A debenture can be described as a debt instrument issued by a company to the public in order
to raise funds for medium or long-term usage. It is just like a bank loan, with debt obligation
and liability for interest payment, but instead of borrowing from a bank, these are issued and
traded in the capital market. A debenture is a legal document that states the amount invested or
lent, interest due, and the repayment plan. At the conclusion of the term, the investor receives
the principal and interest.

According to Section 2 (12) of the Indian Companies Act 1956, “a debenture is a document
which either creates a debt or acknowledges it.”

Generally, debentures are issued with a fixed rate of interest, which is called the Coupon Rate.
A debenture holder receives interest according to the coupon rate specified in the debenture
certificate.

Funds can be generated by a lot of sources in a business organization. The easiest method is
the public issuance of securities. However, private companies cannot use this method as per
legal obligation. The two widely used instruments to generate funds from the market are shares
and debentures. In the case of Equity shares, ownership of the company is compromised.
Hence, if the said company does not want to compromise the ownership, issuing debentures
could be a better option. Such companies can then borrow the funds required by issuing
debentures.

Types of Debentures

Debentures can be categorized on the following basis:

A. On the basis of Security:

• Secured Debentures: Debentures that are issued against a security/collateral are called
secured debentures. In other words, a charge is made against the assets of the
issuing company.
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• Unsecured Debentures: Debentures which are issued without any charge against the
issuing company’s assets are called unsecured debentures.

B. On the basis of Tenure:

• Redeemable Debentures: Such debentures, which are due to be repaid at the end of a
certain period, either in a lump sum or in installments, either at a premium or at face
value, during the lifetime of the entity are called redeemable debentures.

• Irredeemable Debentures: Such debentures are not redeemed or repaid during the
lifetime of the company. In the event of the winding-up of the company, such
redemption may be possible.

C. On the basis of Convertibility:

• Convertible Debentures: Debentures that can be converted into either equity capital
or any other security are called convertible debentures. This can be done at the will of
the holders of the company.

• Non- Convertible Debentures: Debentures which cannot be converted into equity

shares or any other form of security are called non-convertible debentures.

D. On the basis of Coupon Rate:

• Specific Coupon Rate Debentures: These debentures are issued at a specific rate of
interest, called the coupon rate. This interest is payable to the holders periodically,
regardless of whether the company made a profit that year or not.

• Zero-Coupon Rate Debentures: Such debentures do not carry any interest rate. To
compensate the holders, these are usually issued at a discount so that the difference
between the face value and the issue price can be treated as the interest income earned
by the holder.

E. On the basis of Registration:

• Registered Debentures: Debentures against which all information about their holders,
like names, addresses, etc. are kept in a special register at the company’s head office
are called registered debentures. Such debentures cannot be transferred just by delivery,
but require a transfer deed.
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• Bearer Debentures: These debentures are transferred via simple delivery and no
special record is kept in the company register for such documents.

Advantages of Debentures

1. To Investors

• Fixed Income for Investors: A company has to pay interest on the issued debentures,
whether it earns profits in a financial year or not. So, the investors get a fixed income.
This is not the case with equity shareholders, whose dividend depends solely on the
profit earned.

• Secured Investment: Since debt securities are usually secured by way of a charge
against the issuing company’s assets, the holders can sell off the asset in case of the
company goes bankrupt or insolvent.

• Fixed Return even during Inflation: The rate of interest on debentures does not
fluctuate with the changes in price levels, thereby ensuring a fixed level of income.

2. To the Company

• No Dilution of Ownership: Since debenture holders do not have any voting rights or
any participation in company meetings, the ownership of the company’s management
remains intact, as opposed to companies issuing equity capital where control is diluted
owing to voting rights to the holders.

• Cheaper Source: Flotation costs and listing costs for debentures are way lesser than
those of equity capital, making them a cheaper source of funds for the company.

Disadvantages of Debentures

1. To Investors

• No Voting Rights: Debenture holders are not allowed to participate in company

meetings and do not have voting rights. Thus they do not have any say in the company
matters or policies.

2. To the Company

• Rigidity as to Interest Payment: A company issuing equity capital can fix the
dividend rate as per the profit earned, but the same is not possible for a company issuing
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debentures, where the rate of interest is fixed, and interest has to be paid whether there
is profit or not.

• Less control over Mortgaged Assets: Assets against which charges are made cannot
be employed freely for the company’s uses because they are under the control of the
creditors. This leads to the underutilization of assets and resources.

Retained Earnings as a Source of Finance

Retained earnings refer to the portion of a company's net profits that is not distributed to
shareholders as dividends but is instead reinvested back into the business. It appears under the
equity section of the balance sheet and accumulates over time as the company continues to earn
profits and retain a portion of them.

Retained Earnings are that part of the profits of an organisation, which remains with it after
meeting all its operating expenses and paying out dividends to all the shareholders. The
organization intends to keep this surplus amount with itself in the form of reserves and surplus
to meet any contingency, carry out research work, expansion projects, etc.

Concept of Retained Earnings

• Retained earnings are internally generated funds.

• They represent the cumulative amount of profits ploughed back into the company since
its inception.

• These earnings can be used for:

✓ Business expansion
✓ Modernization or R&D
✓ Debt repayment
✓ Working capital requirements
✓ Acquisition of assets

• It is considered a self-financing method and does not involve any external liabilities or
dilution of ownership.

Features of Retained Earnings

The features of Retained Earnings are as follows:

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Cushion of Security: Retained earnings are considered as a cushion of security because they
provide support in times of adversity when it becomes difficult for a firm to raise funds from
other projects.

Funds for Innovative Projects: Retained earnings are a common source of funds for financing
risky and innovative projects. These are generally used for research work, expansion projects,
etc.

Medium and Long-term Finance: Retained earnings are considered as ownership funds and
serve the purpose of medium and long-term finance.

Conversion into Ownership Securities: Surplus retained earnings can be converted into
ownership funds by way of issue of bonus shares. No cash outflow is involved in issuing bonus
shares. Investors too are benefitted from the issue of shares free of cost.

Advantages of Retained Earnings

The advantages of Retained Earnings are as follows:

• Most Dependable Source: Being an internal source, retained earnings are a more
dependable and permanent source of finance than external sources of funds. This is
because all external sources depend upon market conditions, the preference of the
creditors, etc.

• No Explicit Cost: Using retained earnings does not involve any costs to be incurred
as no expenditure is to be made on issuing prospectus, advertising, floatation costs,
etc.

• No Fixed Liability: There is no fixed liability to pay dividends or interest on

this source of funds as retained earnings are a company’s own money.

• No Interference: When a company utilizes its retained profits, it does not need to
issue any new shares. As a result, there is no risk of dilution of control in the
organization.

• No Security: Unlike debentures, no charge is created on the assets of the company.

As a result, the company is free to use its assets for raising loans in the future.
 FINANCE & BANKING 21BSO662

• Goodwill: Retained earnings add to the financial strength and credibility of the
company. Large reserves enable businesses to respond with ease to any crisis or
unforeseen contingency. Retained earnings may lead to an increase in the market price
of the equity shares.

• Absorbs Unexpected Losses: If a business has retained earnings, then it is in the

position to absorb unexpected losses.

Limitations of Retained Earnings

Retained Earning has the following limitations:

• Dissatisfaction: In cases of excessive ploughing back of profits, i.e., where a major

portion of the profits has been kept in the form of reserves, the shareholders might be
disappointed by the lower amounts of dividends paid to them.

• Uncertainty: Retained earnings are a highly uncertain method of raising funds since
the profits of a business are always fluctuating.

• Opportunity Cost: The opportunity cost associated with the usage of retained profits
is often overlooked or sometimes, not even recognized by a lot of firms, which leads
to sub-optimal usage of the funds.

• Over-reliance may reduce dividend payouts, upsetting shareholders.

• Misuse of retained funds in unprofitable projects can lead to inefficiency.

• May indicate lack of profitable reinvestment opportunities if retained excessively.

Potential Benefits of Retained Earnings

Benefit Explanation

No Repayment Unlike loans or debentures, there is no need to repay retained

Obligation earnings.

It is a cost-effective source as it does not require interest

No Interest Cost
payments.

Ownership Preservation Does not dilute ownership as issuing new equity would.
 FINANCE & BANKING 21BSO662

Benefit Explanation

Enhances Financial Improves equity base, making the company more attractive to
Stability lenders/investors.

Flexible Use of Funds Management has full control over how the funds are used.

Supports Long-Term Provides a sustainable source of internal financing for strategic

Growth investments.

Readily available as and when needed, unlike bank loans that

Quick Availability
involve procedures.

Retained earnings are a vital and low-risk source of finance for companies, especially those in
growth stages. By reinvesting profits wisely, companies can improve their financial health,
maintain independence, and create long-term shareholder value.

Concept of trade credit and its relevance as a financing option for a business

Trade credit is a short-term financing arrangement where a supplier allows a business to

purchase goods or services on credit, with payment deferred to a future date — typically within
30, 60, or 90 days.

Trade credit is credit given by one merchant to another for the purchase of products and
services. Trade credit allows for the purchase of materials without the need for immediate
payment. Such credits appear as ‘sundry creditors’ or ‘accounts payable in the records of the
buyer of goods. Business organisations frequently utilise trade credit as a form of short-term
finance.

It is offered to customers that have a good financial status and reputation. The amount and
period of credit provided are determined by factors, such as the purchasing firm’s reputation,
the seller’s financial status, the volume of purchases, the seller’s payment history, and the
degree of market competition. Trade credit terms might differ from one industry to another and
from one customer to another.
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Instead of paying cash immediately, the buyer agrees to pay after a specific credit period, as
per the terms of the invoice. It is one of the most common and informal sources of working
capital finance.

Key Features of Trade Credit:

✓ It is an unsecured, interest-free credit arrangement in most cases.

✓ Based on mutual trust and business relationship.
✓ No formal loan agreement is required.
✓ Payment terms are usually written on the invoice (e.g., “net 30” means payment is due
in 30 days).
✓ Some suppliers may offer cash discounts for early payments (e.g., "2/10 net 30" means
2% discount if paid within 10 days).

Relevance of Trade Credit as a Financing Option:

1. Enhances Liquidity Allows businesses to use the goods immediately while deferring
payment, improving cash flow.

2. Supports Working Capital Helps businesses manage day-to-day operations without tying up
cash in inventory.

3. No Interest Cost Generally interest-free if payment is made within the credit period.

4. Easy to Obtain No collateral or formalities required; depends on creditworthiness and

relationships.

5. Builds Supplier Relationships Consistent use and timely repayment of trade credit can
strengthen supplier trust.

6. Encourages Bulk Purchases Businesses can buy more than they could afford with
immediate payment.

Advantages of Trade Credit

The advantages of Trade Credit are as follows:

1. Business Growth: The two main obstacles to worldwide business expansion are: The
capacity to pay vendors for products or services delivered, and the risk of non-
payment. Trade credit is a kind of short- to medium-term working capital that offers
security on the product or service being exported or imported, enabling multinational
 FINANCE & BANKING 21BSO662

enterprises to overcome these hurdles more effectively. As a result, business growth is

facilitated.

2. Continuous Source: Trade Credit is a continuous and convenient source of funds,

which is easily available to firms

3. Easily Available: If the creditworthiness of the customers is known to the seller, trade
credit may be readily available to customers.

4. Increase in Sales: Trade Credit can be used if an organisation wants to increase its
inventory level in order to meet the expected rise in the sales volume in the near
future.

5. No Charge on Assets: It does not create any charge on the assets of the firm while
providing funds.

Disadvantages of Trade Credit

The disadvantages of Trade Credit are as follows:

1. Cash Flow Effect: The most obvious effect of trade credit is that merchants do not
receive instant payment for their goods. Sellers have their own costs to pay, and
offering credit terms to buyers disrupts their financial flow.

2. Overtrading: Trade Credit allows businesses to avail credit facilities easily, which
may induce a firm to indulge in overtrading, which may add to the risks of the firm.

3. Limited Funds: Only a limited amount of funds can be generated through trade
credit, so it is not very useful if a business required heavy funds.

4. Investigate Creditworthiness of Customers: A vendor who gives credit to consumers,

like a bank examines their credit ratings. This requires both money and time. Obtaining
company credit reports, such as Dun & Bradstreet, is expensive, and calling references
takes time. A vendor may need to recruit an additional person with credit analysis
expertise to assist in making choices about extending payment terms.

5. Financing Accounts Receivable: The seller must finance these receivables since credit
terms have been extended to buyers. To receive trade credit, a seller may have to rely
on his own suppliers, borrow on his bank line of credit, or use the company’s
accumulated retained earnings. Each of these approaches has an inherent capital cost.
 FINANCE & BANKING 21BSO662

6. Increase in Cost: Trade financing, like any other loan instrument, has a cost because
trade financing is only charged on the particular trades carried out under the facility. It
is essential to comprehend the profit margins on trades. If a company understands its
profit margins and costs, the financing cost may be included in the trade costing. It is
also more costly than other sources of raising money.

Trade credit is a valuable and flexible short-term financing tool, especially for small and
medium-sized businesses (SMEs). It enables companies to conserve cash, manage inventory,
and maintain uninterrupted operations without the need for formal loans. However, prudent
management of trade credit is essential to maintain good supplier relationships and avoid
liquidity issues.

Public Deposits: Advantages and Disadvantages

Public deposits are deposits collected directly from the public by organisations. Interest rates
on public deposits are typically higher than those on bank deposits. Anyone who is interested
in making a monetary contribution to an organisation may do so by completing a prescribed
form. In exchange, the organisation issues a deposit receipt as proof of debt. A business’s
medium and short-term financial needs can be met by public deposits.

Deposits are advantageous to both the depositor and the organisation. While depositors receive
higher interest rates than banks, the cost of deposits to the company is lower than the cost of
borrowing from banks. Companies invite additional public deposits for up to three years. The
Reserve Bank of India regulates the acceptance of public deposits. Public deposits are an
important source of financing for a company’s short-term requirements. Companies typically
receive public deposits for terms ranging from 6 to 36 months. The deposit of small amounts
of savings by the public with industrial and business institutions for a specified period at
specified rates of interest in order to earn profits is referred to as public deposit.

Advantages of Public Deposits

The advantages of Public Deposits are as follows:

1. Simple Procedures: The procedure for obtaining deposits is simple and does not include
any restrictive conditions that are normally found in a loan agreement.

2. Cost-Effective: The cost of public deposits is generally lower than the cost of borrowing
from banks and financial institutions. Obtaining public deposits is very cost-effective.
 FINANCE & BANKING 21BSO662

Companies do not need to spend money on prospectus and underwriter commissions. The
interest paid on public deposits is lower than the interest paid on other borrowed funds.

3. No Charge on Assets: Public deposits do not usually impose a charge on the company’s
assets. The assets can be used as collateral for obtaining loans from other sources.

4. Control: The company’s control is not diluted, as depositors have no voting rights.

5. Boosts creditworthiness: Public deposits are unsafe. The company’s assets can be used as a
mortgage in the future. This boosts the company’s creditworthiness.

6. Few Legal Requirements: There are fewer legal requirements for issuing and obtaining
funds from public deposits. Companies do not require permission from the controller of capital
and are not required to be listed on any stock exchange market, as is the case with shares and
debentures.

Disadvantages of Public Deposits

The disadvantages of Public Deposits are as follows:

1. Difficult for New Companies: It is generally difficult for new businesses to raise funds
through public deposits.

2. Unreliable Source: It is an unreliable source of finance because the public may not respond
when the company requires funds. Deposits may not respond in a capital market collapse.
Furthermore, the company’s deposits are volatile.

3. Difficulty in Collection: Collecting public deposits may be difficult, especially if the

deposits required are large.

4. Limited Amount: Due to legal constraints, the amount of money that can be raised through
public deposits is limited. The amount of public deposits cannot exceed 25% of the share capital
and free reserves.

5. Not Ideal for Long-term Financing: A company cannot depend on public deposits for long-
term financing because their maturity period ranges from six months to three years.
 FINANCE & BANKING 21BSO662

Commercial Banks : Features, Advantages & Disadvantages

A commercial bank is a financial institution that provides services like accepting deposits,
granting loans, bank overdrafts, offering certificates of deposits, and savings accounts to
individuals and businesses. Commercial banks are considered to be an important component
of the banking system. These are the banks that perform banking services with the aim of
earning profits. Commercial banks are generally famous because they provide funds for a
different span of time: short-term & medium-term. Also, commercial banks are very active in
accepting deposits. Usually, the rate of interest charged on the loans is more than the interest
offered on the deposits. The disparity between both interest rates then becomes the primary
source of income or profits for the banks. Common examples of commercial banks are the State
Bank of India (SBI), Bank of Baroda, Punjab National Bank (PNB), Central Bank of India,
Canara Bank, Bank of India, etc.

Characteristics of Commercial Banks

1. Commercial banks lend money to almost all sizes of businesses and firms.

2. The credibility and paying capacity of the firm is examined comprehensively before
lending loan to any firm.

3. A commercial bank is an easy and flexible source of accepting and withdrawing money.

4. These are the economical source of funds as it manages deposits and withdrawals at a
low cost and involves no hidden cost.

5. It generally provides the loan against some security.

6. Loans from commercial banks do not require much formality, but have to fulfil the
terms and conditions laid by the banks.

Advantages of Commercial Bank

The advantages of Commercial Banks are as follows:

1. Confidentiality of Information: The banks when lends funds or accept deposits do not
share the information with anyone. Banks value the privacy of their customers by preserving
the secrecy of personal information of customers. The personal details of the customers or the
account holders are kept safe with the banks.
 FINANCE & BANKING 21BSO662

2. Economical: Commercial banks are widely regarded as the cheaper funding source. The
reason for its being an economical source is that it does not involves any cost for issuing of a
prospectus, underwriting fees or any other charges. Banking services under commercial banks
are free from any sort of hidden charges.

3. Flexible: Commercial banks are considered to be a flexible source of funding because the
borrower can easily borrow money from the banks whenever they are in urgent need of money
or funds. The borrowers can easily increase or reduce the amount of borrowings as per their
convenience and requirements. The banks make the funds available as and when needed by the
borrowers. Also, borrowers can repay the money when they don’t feel the requirement.

4. Lesser Formalities: It’s easy for borrowers to raise funds from commercial banks because
it requires no stringent formalities to follow up. As such no paperwork is involved in the whole
borrowing process. It requires no formalities like looking for an underwriter or issuing of a
prospectus. So, it makes the process hassle-free and smooth.

5. Encourage Savings: Commercial Banks through their operations encourage savings among
the general public. With this facility, banks offer a safer way to collect money from individuals,
which otherwise they could have consumed impulsively. The amount of savings is subject to
some fixed rate of interest. So savings from individuals whether in small or big amount
increases the capital accumulation with the banks, which then can be used to invest or lend to
the general public.

6. Facilitates Digital Transactions: With the growth of digitisation, commercial banks have
emerged as significant financial institution because it provides a technologically advanced
platform for making digital payments. Apart from basic facilities, it makes online transfers
easy, use of cheques, ATMs, bank drafts, etc. A very few and recent development of commercial
banks is the facility of online wallet. Earlier individuals and businessmen had to handle a lot
of money which was subjected to theft, but now they can keep their money safe in the wallets
and can use to make digital payments.

Disadvantages of Commercial Bank

The disadvantages of Commercial Banks are as follows:

1. Procedural Difficulty: While lending funds to borrowers, it’s important for commercial
banks to check if the advances are being made to the right entity. The only way to check is to
 FINANCE & BANKING 21BSO662

conduct a detailed investigation of the firm’s background and its financial affairs. It follows
stringent rules, so it makes the procedure of borrowing very tricky and rigorous.

2. Difficulty in Renewal: Loans from Commercial Banks can be generally borrowed for a
short period of time only. It’s almost difficult to renew or extend the borrowings. Also,
extending the tenure of borrowed funds can be tough and only fresh loans can be borrowed.

3. Need for Security: Loans from commercial banks can’t be provided without any security.
For any amount of loan or advances, there is a requirement of any asset or personal guarantees
from the borrowers against which borrowings can be issued. Most of the time, the loan amount
is lower than the security’s value. So it has become disadvantageous for the public and firms.

4. Stringent Terms and Conditions: Commercial banks sometimes put forward a few
challenging conditions for borrowers before lending loans or funds. At times, terms and
conditions are so difficult to fulfil that it hampers the complete borrowing process. So, this
restricts the borrowing decision of firms that they even back out from this source of funds and
shift to some other source of funds with some feasible terms and conditions.

5. Bankruptcy: Sometimes, the banks may not be capable to provide the amount requested by
the borrowers even if that money belongs to the customers and they have only deposited those
to their savings account. This happens when the management of the banks does not take proper
care of depositors’ or investors’ finances and rather mismanages them. But sometimes, it could
also happen due to weaker economic health, like in times of recession when customers do more
withdrawal than borrowings.

6. Risk of Online Frauds: Growing digitisation has not only soothed operations but also has
given rise to online frauds. Cyber attacks have become more common and often nowadays,
ATM cards are more subjected to theft, hackers hack the accounts and passwords for digital
payments, and steal money online. There’s an urgent need to strengthen the game of internet
banking.

On the whole, it can be concluded that commercial banks are a very crucial component of the
whole Banking system. Also, gradually with time, the outlook of commercial banks is
expanding with regard to the economy. Commercial Banks offer a proper organised financial
market in less developed countries by providing financial assistance and fulfilling the financial
needs of individuals, firms and businesses.
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Factors Affecting the Choice of the Source of Funds

Every organization requires capital to run its daily operations. The initial capital of a firm can
never be sufficient for the proper running of the business. Therefore, it has to identify and
estimate the financial needs and different sources from where funds can be arranged. A business
can run its operations effectively and efficiently if it has adequate funds and makes the best use
of them. Different types of businesses have different types of financial needs. Therefore,
business firms resort to different types of sources of funds. As no source of funds is free from
risk and limitations, companies usually use a combination of sources rather than relying on a
single source. Different factors that affect the choice of the source of funds are as follows:

1. Cost

When an organization acquires funds it has to incur some costs. Cost is a major element, as it
directly affects an enterprise. Therefore, the cost of procurement of funds, as well as the cost
of utilizing the funds are taken into consideration while deciding the choice of funds, that will
be used by an organization.

2. Financial Strength and Stability of Operations

A company’s financial strength and position are key elements to be taken into account while
deciding the source of funds. Funds need to be repaid to the source from where it has been
generated from, so for this, a business should be financially stable. When the earning position
of the business is not stable, fixed-charged funds like preference shares and debentures should
not be taken.

3. Form of Organization and Legal Status

The legal status (i.e., sole proprietorship, partnership or company) of a business allows or
prohibits choosing from various options of funds. Therefore, an organization has to take its
legal status and form into consideration while choosing the source of funds. For example, only
a public company can issue equity shares to raise money from the market, not a partnership
business or even a private company.

4. Purpose and Period

The purpose and period are important factors that affect the choice of source of funds. Every
organization has its financial needs for different purposes. Some need the funds for capital
expansion, some for their survival, etc. Therefore, a firm has to properly define its purpose of
 FINANCE & BANKING 21BSO662

financial needs for the selection of the source. Besides, the number of sources from which an
organization can choose funds for the short term is more than the number of sources available
from which an organization can choose funds for the long term. Therefore, the time period also
plays a major role in deciding the source of funds.

5. Risk Profile

Every source of funds involves some kind of risk. The risk factor associated with a different
type of source of finance varies from each other. For example, there is the least risk in equity
as the share capital has to be repaid only at the time of winding up, and dividends need not be
paid if there is no profit, but debentures are the opposite in terms of payment of interest.

6. Control

Some sources of funds require sacrificing the firm’s control over the business, while some of
them do not involve sacrificing control. Therefore, a company has to decide whether or not it
wants to sacrifice its control over the company before choosing the perfect source of funds. For
example, If a company want to generate fund from issuing equity shares, then it has to sacrifice
a bit of ownership and control to the public, whereas by issuing debt funds, like debentures or
taking a loan, a company does not have to compromise with ownership and control.

7. Effect on Credit Worthiness

Credit Worthiness is the company’s power or ability to repay debts. Some source of funds
affects the creditworthiness of a company negatively. Hence, a company may choose not to
consider those options while selecting the source of finance.

8. Flexibility and Ease

Flexibility and ease of a source of funds play a crucial role in its selection. Generally, an
organization prefers options which are more flexible and easy rather than those which have
restrictive provisions, detailed investigation and documentation.

9. Tax Benefits

Various sources offer different tax benefits to the organization. The dividend on preference
shares is not deductible from the taxable income, but the interest paid on debentures and loans
is tax-deductible.