UNIT IV

Financial Need of Business Methods

 The business world orbits around capital.

Financial activity stimulates economic growth and
keeps companies prosperous.
 However, not all businesses start out with an
adequate amount of funding, so business owners
need to explore financing options. If fledgling
companies do not have proper capital to get their
business off the ground, they won't have a high
chance of survival against industry competitors.
Financial Institutions

 Business owners have the option of taking out a loan at a

financial institution.
 Financial institutions, such as banks or credit unions, offer
lines of credit to businesses that are just starting out or require
financial assistance for improvements or new developments.
 To qualify for a loan, business owners must go through an
application process. Most financial institutions require
businesses to provide proposals for how the money will be
used and why the funding is necessary.
 Interest on the loan will be charged at either a fixed or variable
rate.
 Venture Capitalists

 Another financing method is to find a venture capitalist to fund your business endeavor.
 A venture capitalist (VC) is a private equity investor that provides capital to companies with
high growth potential in exchange for an equity stake. This could be funding startup
ventures or supporting small companies that wish to expand but do not have access to equities
markets.
 Venture capitalists usually want to invest in high-growth companies and seek out companies
that show promising signs of a high return on the investment.
 One of the benefits of this financing method is that venture capitalists are not afraid to take
risks, whereas financial institutions like to lend money to safer enterprises.
Home Equity Line of Credit

 Taking out a home equity line of credit on

your home is another method for financing
your business venture.
 Business owners who also own homes can
access money from their home equity to
fund their company activities. Interest on
home equity lines of credit is often lower
than that charged on a commercial bank
loan.
 Friendly Loans

 If you have friends and family with money, you

might consider asking them for a friendly loan.
They may have an interest in your business and
will want to invest in it, expecting a good return
on their investment. Or they may wish to loan
you the money and expect only that they will be
paid back. This option is more desirable than
commercial bank loans that charge high interest
rates.
 Sources of Finance

 Finance is Significant for business it can not carry out its operations even a single day without finance. It is
therefore important to search the source from here the fund can be collected. The selection
The financial needs of a business can be categorised as follows:
Fixed capital requirements: In order to start business, funds are required to purchase fixed assets like land and
building, plant and machinery, and furniture and fixtures. This is known as fixed capital requirements of the
enterprise. The funds required in fixed assets remain invested in the business for a long period of time.
Working capital requirements: The financial requirements of an enterprise do not end with the procurement of
fixed assets. No matter how small or large a business is, it needs funds for its day-to-day operations. This is
known as working capital of an enterprise, which is used for holding current assets such as stock of material, bills
receivables and for meeting current expenses like salaries, wages, taxes, and rent. The amount of working capital
required varies from one business concern to another depending on various factors.
 Classification of Sources of Funds

 In case of proprietary and partnership concerns, the funds may be raised either from personal sources or
borrowings from banks, friends etc.
 In case of company form of organisation, the different sources of business finance which are available
may be categorised, the sources of funds can be categorised using different basis viz.,
 On the basis of the period
 On the basis of source of generation
 On the basis of the ownership
 On the basis of Period

 On the basis of period, the different sources of funds can be categorised into three parts. These are long-term
sources, medium-term sources and short-term sources. The long-term sources fulfil the financial requirements
of an enterprise for a period exceeding 5 years and include sources such as shares and debentures, long-
term borrowings and loans from financial institutions. Such financing is generally required for the
acquisition of fixed assets such as equipment, plant, etc. Where the funds are required for a period of more
than one year but less than five years, medium-term sources of finance are used. These sources include
borrowings from commercial banks, public deposits, lease financing and loans from financial institutions.
Short-term funds are those which are required for a period not exceeding one year. Trade credit, loans
from commercial banks and commercial papers are some of the examples of the sources that provide funds
for short duration. Short-term financing is most common for financing of current assets such as accounts
receivable and inventories. Seasonal businesses that must build inventories in anticipation of selling
requirements often need short-term financing for the interim period between seasons. Wholesalers and
manufacturers with a major portion of their assets tied up in inventories or receivables also require large
amount of funds for a short period
 8.3.2 Ownership Basis

 On the basis of ownership, the sources can be classified into ‘owner’s funds’ and ‘borrowed funds’.
Owner’s funds means funds that are provided by the owners of an enterprise, which may be a sole
trader or partners or shareholders of a company. Apart from capital, it also includes profits
reinvested in the business. The owner’s capital remains invested in the business for a longer
duration and is not required to be refunded during the life period of the business. Such capital
forms the basis on which owners acquire their right of control of management. Issue of equity
shares and retained earnings are the two important sources from where owner’s funds can be
obtained. ‘Borrowed funds’ on the other hand, refer to the funds raised through loans or
borrowings. The sources for raising borrowed funds include loans from commercial banks, loans
from financial institutions, issue of debentures, public deposits and trade credit. Such sources
provide funds for a specified period, on certain terms and conditions and have to be repaid after the
expiry of that period. A fixed rate of interest is paid by the borrowers on such funds. At times it puts
a lot of burden on the business as payment of interest is to be made even when the earnings are low
or when loss is incurred. Generally, borrowed funds are provided on the security of some fixed
assets
Source of Generation Basis

 Another basis of categorising the sources of funds can be whether the funds are generated from
within the organisation or from external sources. Internal sources of funds are those that are
generated from within the business. A business, for example, can generate funds internally
by accelerating collection of receivables, disposing of surplus inventories and ploughing
back its profit. The internal sources of funds can fulfill only limited needs of the business.
External sources of funds include those sources that lie outside an organisation, such as
suppliers, lenders, and investors. When large amount of money is required to be raised, it is
generally done through the use of external sources. External funds may be costly as
compared to those raised through internal sources. In some cases, business is required to
mortgage its assets as security while obtaining funds from external sources. Issue of
debentures, borrowing from commercial banks and financial institutions and accepting
public deposits are some of the examples of external sources of funds commonly used by
business organisations
8.4 Sources of Finance

 A business can raise funds from various sources. Each of the source has unique
characteristics, which must be properly understood so that the best available source of
raising funds can be identified. There is not a single best source of funds for all
organisations. Depending on the situation, purpose, cost and associated risk, a choice
may be made about the source to be used. For example, if a business wants to raise
funds for meeting fixed capital requirements, long term funds may be required
which can be raised in the form of owned funds or borrowed funds. Similarly, if the
purpose is to meet the day-to-day requirements of business, the short term sources
may be tapped. A brief description of various sources, along with their advantages and
limitations is given below
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. This is known as retained earnings. It is a source of internal financing or self
financing or ‘ploughing back of profits’. The profit available for ploughing back in
an organisation depends on many factors like net profits, dividend policy and age of
the organization.
Trade Credit

 Trade credit is the credit extended by one trader to another for the purchase of goods and services.
Trade credit facilitates the purchase of supplies without immediate payment. Such credit appears in
the records of the buyer of goods as ‘sundry creditors’ or ‘accounts payable’. Trade credit is
commonly used by business organisations as a source of shortterm financing. It is granted to those
customers who have reasonable amount of financial standing and goodwill. The volume and period of
credit extended depends on factors such as reputation of the purchasing firm, financial position of the
seller, volume of purchases, past record of payment and degree of competition in the market. Terms of
trade credit may vary from one industry to another and from one person to another. A firm may also
offer different credit terms to different customers.
 Factoring

 Factoring is a financial service under which the ‘factor’ renders various services which includes: (a) Discounting of
bills (with or without recourse) and collection of the client’s debts. Under this, the receivables on account of sale of
goods or services are sold to the factor at a certain discount. The factor becomes responsible for all credit control
and debt collection from the buyer and provides protection against any bad debt losses to the firm. There are two
methods of factoring — recourse and non-recourse. Under recourse factoring, the client is not protected against the
risk of bad debts. On the other hand, the factor assumes the entire credit risk under nonrecourse factoring i.e., full
amount of invoice is paid to the client in the event of the debt becoming bad.
 (b) Providing information about credit worthiness of prospective client’s etc., Factors hold large amounts of
information about the trading histories of the firms. This can be valuable to those who are using factoring services
and can thereby avoid doing business with customers having poor payment record. Factors may also offer relevant
consultancy services in the areas of finance, marketing, etc. The factor charges fees for the services rendered.
Factoring appeared on the Indian financial scene only in the early nineties as a result of RBI initiatives. The
organisations that provides such services include SBI Factors and Commercial Services Ltd., Canbank Factors Ltd.,
Foremost Factors Ltd., State Bank of India, Canara Bank, Punjab National Bank, Allahabad Bank. In addition,
many nonbanking finance companies and other agencies provide factoring service.
Lease Financing

 A lease is a contractual agreement whereby one party i.e., the owner of an asset
grants the other party the right to use the asset in return for a periodic payment. In
other words it is a renting of an asset for some specified period. The owner of the
assets is called the ‘lessor’ while the party that uses the assets is known as the ‘lessee’
(see Box A). The lessee pays a fixed periodic amount called lease rental to the lessor
for the use of the asset. The terms and conditions regulating the lease A lease is a
contractual agreement whereby one party i.e., the owner of an asset grants the other
party the right to use the asset in return for a periodic payment. In other words it is
a renting of an asset for some specified period. The owner of the assets is called the
‘lessor’ while the party that uses the assets is known as the ‘lessee’ (see Box A). The
lessee pays a fixed periodic amount called lease rental to the lessor for the use of the
asset. The terms and conditions regulating the lease
8.4.5 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. Any person who is interested in depositing money in
an organisation can do so by filling up a prescribed form. The organisation in return
issues a deposit receipt as acknowledgment of the debt. Public deposits can take care
of both medium and short-term financial requirements of a business. The deposits
are beneficial to both the depositor as well as to the organisation. While the
depositors get higher interest rate than that offered by banks, the cost of deposits to
the company is less than the cost of borrowings from banks. Companies generally
invite public deposits for a period upto three years. The acceptance of public deposits
is regulated by the Reserve Bank of India
8.4.6 Commercial Paper

 Commercial Paper (CP) is an unsecured money market instrument issued in the

form of a promissory note. It was introduced in India in 1990 for enabling highly
rated corporate borrowers to diversify their sources of short-term borrowings and to
provide an additional instrument to investors. Subsequently, primary dealers and
all-India financial institutions were also permitted to issue CP to enable them to meet
their short-term funding requirements for their operations. Individuals, banking
companies, other corporate bodies (registered or incorporated in India) and
unincorporated bodies, NonResident Indians (NRIs) and Foreign Institutional
Investors (FIIs) etc. can invest in CPs. CP can be issued for maturities between a
minimum of 7 days and a maximum of up to one year from the date of issue in
denominations of Rs.5 lakh or multiples thereof. However, the maturity date of the
CP should not go beyond the date up to which the credit rating of the issuer is valid.
 Issue of Shares

 The capital obtained by issue of shares is known as share capital. The capital of a company is divided into small units called shares. Each share has
its nominal value. For example, a company can issue 1,00,000 shares of Rs. 10 each for a total value of Rs. 10,00,000. The person holding the share is
known as shareholder. There are two types of shares normally issued by a company. These are 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.
 (a) Equity Shares Equity shares is the most important source of raising long term capital by a company. Equity shares represent the ownership of a
company and thus the capital raised by issue of such shares is known as ownership capital or owner’s funds. Equity share capital is a prerequisite to
the creation of a company. Equity shareholders do not get a fixed dividend but are paid on the basis of earnings by the company. They are referred
to as ‘residual owners’ since they receive what 2021-22 190 BUSINESS STUDIES is left after all other claims on the company’s income and assets
have been settled. They enjoy the reward as well as bear the risk of ownership. Their liability, however, is limited to the extent of capital contributed
by them in the company. Further, through their right to vote, these shareholders have a right to participate in the management of the company.
 (b) Preference Shares The capital raised by issue of preference shares is called preference share capital. The preference shareholders enjoy a
preferential position over equity shareholders in two ways: (i) receiving a fixed rate of dividend, out of the net profits of the company, before any
dividend is declared for equity shareholders; and (ii) receiving their capital after the claims of the company’s creditors have been settled, at the time
of liquidation. In other 2021-22 SOURCES OF BUSINESS FINANCE 191 words, as compared to the equity shareholders, the preference
shareholders have a preferential claim over dividend and repayment of capital. Preference shares resemble debentures as they bear fixed rate of
return. Also as the dividend is payable only at the discretion of the directors and only out of profit after tax, to that extent, these resemble equity
shares. Thus, preference shares have some characteristics of both equity shares and debentures. Preference shareholders generally do not enjoy any
voting rights. A company can issue different types of preference shares (see Box B)
Debentures

 Debentures are an important instrument for raising long term debt capital. A company can
raise funds through issue of debentures, which bear a fixed rate of interest. The debenture
issued by a company is an acknowledgment that the company 2021-22 192 BUSINESS
STUDIES has borrowed a certain amount of money, which it promises to repay at a future
date. Debenture holders are, therefore, termed as creditors of the company. Debenture
holders are paid a fixed stated amount of interest at 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.) on aspects like
track record of the company, its profitability, debt servicing capacity, credit worthiness and
the perceived risk of lending. A company can issue different types of debentures (see Box C
and D). Issue of Zero Interest Debentures (ZID) which do not carry any explicit rate of
interest has also become popular in recent years. The difference between the face value of
the debenture and its purchase price is the return to the investor
Commercial Banks

 Commercial banks occupy a vital position as they provide funds for different
purposes as well as for different time periods. Banks extend loans to firms of all sizes
and in many ways, like, cash credits, overdrafts, term loans, purchase/discounting of
bills, and issue of letter of credit. The rate of interest charged by banks depends on
various factors such as the characteristics of the firm and the level of interest rates in
the economy. The loan is repaid either in lump sum or in installments. Bank credit is
not a permanent source of funds. Though banks have started extending loans for
longer periods, generally such loans are used for medium to short periods. The
borrower is required to provide some security or create a charge on the assets of the
firm before a loan is sanctioned by a commercial bank.
8.4.10 Financial Institutions

 The government has established a number of financial institutions all over the
country to provide finance to business organisations (see Box E). These institutions
are established by the central as well as state governments. They provide both owned
capital and loan capital for long and medium term requirements and supplement the
traditional financial agencies like commercial banks. As these institutions aim at
promoting the industrial development of a country, these are also called
‘development banks’. In addition to providing financial assistance, these institutions
also conduct market surveys and provide technical assistance and managerial
services to people who run the enterprises. This source of financing is considered
suitable when large funds for longer duration are required for expansion,
reorganisation and modernisation of an enterprise.
 8.5 International Financing

 In addition to the sources discussed above, there are various avenues for organisations to raise
funds internationally. With the opening up of an economy and the operations of the business
organisations becoming global, Indian companies have an access to funds in global capital BOX D
Inter Corporate Deposits (ICD) Inter Corporate Deposits are unsecured short-term deposits made
by a company with another company. ICD market is used for short-term cash management of a
large corporate. As per the RBI guidelines, the minimum period of ICDs is 7 days which can be
extended to one year. The three types of Inter Corporate Deposits are: (i) Three months deposits;
(ii) Six months deposits; (iii) Call deposits. Interest rate on ICDs may remain fixed or may be
floating. The rate of interest on these deposits is higher than that of banks. These deposits are
usually considered by the borrower company to solve problems of short-term funds insufficiency.
2021-22 196 BUSINESS STUDIES market. Various international sources from where funds may
be generated include:
(i) Commercial Banks:

 Commercial banks all over the world extend foreign currency loans for business purposes.
They are an important source of financing non-trade international operations. The types of
loans and services provided by banks vary from country to country. For example,
Standard Chartered emerged as a major source of foreign currency loans to the Indian
industry.
(ii) International Agencies and Development
Banks:

 A number of international agencies and development banks have emerged over the years
to finance international trade and business. These bodies provide long and medium term
loans and grants to promote the development of economically backward areas in the
world. These bodies were set up by the Governments of developed countries of the world
at national, regional and international levels for funding various projects. The more
notable among them include International Finance Corporation (IFC), EXIM Bank and
Asian Development Bank.
 (iii) International Capital Markets:

 Modern organisations including multinational companies depend upon sizeable borrowings in rupees as well as in foreign currency. Prominent financial instruments
used for this purpose are: (a) Global Depository Receipts (GDR’s): The local currency shares of a company are delivered to the depository bank. The depository
bank issues depository receipts against these shares. Such depository receipts denominated in US dollars are known as Global Depository Receipts (GDR). 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. A holder of GDR can at any time convert it into the number of shares it
represents. The holders of GDRs do not carry any voting rights but only dividends and capital appreciation. Many Indian companies such as Infosys, Reliance,
Wipro and ICICI have raised money through issue of GDRs (see Box F). (b) American Depository Receipts (ADRs): 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 a GDR except that it can
be issued only to American citizens and can be listed and traded on a stock exchange of USA. (c) Indian Depository Receipt (IDRs): An Indian Depository Receipt is
a financial instrument denominated in Indian Rupees in the form of a Depository Receipt. It is created by an Indian Depository to enable a foreign company to raise
funds from the Indian securities market. The IDR is a specific Indian version of the similar global depository receipts. The foreign company issuing IDR deposits
shares to an Indian Depository (custodian of securities registered with the Securities and Exchange Board of India). In turn, the depository issues receipts to investors
in India against these shares. The benefits of the underlying shares (like bonus, dividends, etc.) accrue to the IDR holders in India. According to SEBI guidelines,
IDRs are issued to Indian residents in the same way as domestic shares are issued. The issuer company makes a public offer in India, and residents can bid in exactly
the same format and method as they bid for Indian shares. ‘Standard Chartered PLC’ was the first company that issued Indian Depository Receipt in Indian securities
market in June 2010. (d) Foreign Currency Convertible Bonds (FCCBs): Foreign currency convertible bonds are equity linked debt securities that are to be converted
into equity or depository receipts after a specific period. Thus, a holder of FCCB has the option of either converting them into equity shares at a predetermined price
or exchange rate, or retaining the bonds. The FCCB’s are issued in a foreign currency and carry a fixed interest rate which is lower than the rate of any other similar
non-convertible debt instrument. FCCB’s are listed and traded in foreign stock exchanges. FCCB’s are very similar to the convertible debentures issued in India.
Security Market / Marketable Securities

 Marketable Securities are the financial instruments that one can easily buy or sell in the market.
The maturities of these financial instruments are usually less than a year. Since they have high
liquidity, these investments are good for businesses that need quick cash. Some examples of these
financial instruments are government bonds, common stock or certificates of deposit.

Businesses keep their cash in reserves. Such reserves help them in situations when they require
cash, like for acquisitions or any unforeseen payment. However, companies do not put all their
cash in the reserves. Instead, they invest some in short-term liquid securities to earn interest. This
way, the cash not only earns an interest income, but a company can also easily liquidate the
investment to meet any future cash need.

The returns on such securities are relatively lower due to their liquidity and the fact that we see
them as safe investments. Apple holds a major portion of its wealth in the form of such securities.
WHY INVEST IN THEM?


BETTER THAN IDLE CASH
Cash lying idle does not give any return and cash in the bank account offers meager returns. Therefore,
investing in such securities not just offer a better return, but the safety of investment as well.

PAYING SHORT-TERM LIABILITIES

Short-term liabilities are payable within a year. So, marketable securities, which also liquidate after a year, are
the best way to pay such liabilities as they are highly liquid and earn some income in the meantime as well.

REGULATORY REQUIREMENT
To borrow funds from financial institutions, companies have to follow some guidelines. These guidelines
could be in the form of maintaining a certain level of working capital and investing in cash. Moreover, these
requirements are often in the form of ratios. So, marketable securities help a company meet such guidelines
with liquidity and solvency ratios.
TYPES

 Marketable securities broadly have two groups – Marketable debt securities and Marketable equity securities.

Marketable debt securities are government bonds and corporate bonds. One can trade these on the public exchange and their
market price is also readily available. In the balance sheet, all marketable debt securities are shown as current at the cost, until a
company realizes a gain or loss on the sale of the debt instrument.

Marketable equity securities are common stock and most preferred stock as well. One can also easily trade them on the public
exchanges and their market price information is easily available. All marketable equity securities are shown in the balance sheet
at either cost or market whichever is lower.

There is also a third type of marketable securities classified further into three categories – money market instruments, derivatives,
and indirect investments. Indirect investments include money put into hedge funds and unit trusts.

Derivatives are the investments that are dependent on another security for their value, like futures, options, and warrants.

Money market securities are short-term bonds, like Treasury bills (T-bills), banker’s acceptances and commercial paper. Big
financial entities purchase these in massive quantities.
Money Market

 Types of instruments Traded in the Money Market: Several financial instruments

are created for short term lending and borrowing in the money market.
 1. Treasury Bills: Treasury Bills are considered the safest instruments since they are
issued by the United State Government. They are issued by the U.S. Treasury
regularly to refinance Treasury Bills reaching maturity and to finance the federal
government deficits. They have maturity of one, six, or twelve months. Treasury Bills
are sold at a discount to their face value, and the difference between the discounted
purchase price and face value represent the interest rate. The are purchased by
banks, broker,-dealers, individual investres, pension funds insurance companies and
other large institutions.