Sources of Business Finance Class 11 Notes

An internal source is any finance that the business raises for itself, and the four listed in the chapter are the owner's contribution, the loans taken by the owner, the retained profit, and the sale of assets. None of them requires a payment of interest to a person outside the business.

• The owner's contribution is the capital the owner brings into the business, and it is a permanent source because it does not have to be repaid.
• The owner's loan is a loan taken by the business from the owner, and it is temporary because it has to be repaid with interest at the agreed period, so it differs from the capital only in this respect.
• Retained profit is the portion of the profit earned in a year that is not distributed as dividend to the shareholders and is ploughed back into the business, and it is a very important internal source, because it is a self-generated capital that does not cost anything.
• The sale of assets is the finance raised by selling a piece of land, a machine or a building that the business no longer needs, and it is a temporary source.
• The advantage of the internal source is that it is the cheapest form of finance, because no interest has to be paid and there is no formal legal procedure, and it is the safest, because there is no obligation of repayment to a third party.
• The limitation of the internal source is that it is limited in amount and it is not suitable for the small firms whose growth is rapid, and the retained profit cannot be used for five years when a business has a loss, so the internal source dries up exactly when it is needed most.
• The further limitation is that the internal source is not available to a firm that has a small profit base, and it involves the use of the personal resources of the owner, which is a burden on a limited person.

The external sources are grouped by what the lender receives in return. A loan or a debenture gives the right to a fixed payment, while a share gives the right to a share of the profit and of the control, and this difference is the base of the whole classification.

• Trade credit is the finance obtained by the firm from its suppliers, who allow it to pay for the goods after using them, and the period of credit is short, so it is a short-term source.
• Bank loan and overdraft: a bank loan is a loan given for a fixed period at a fixed rate of interest, while an overdraft allows the firm to withdraw more than the balance in the account up to a sanctioned limit, and the interest is charged on the amount withdrawn, and both are secured sources.
• The Public Deposit is a deposit taken by a company from the public repayable after a fixed period with or without interest, and it is an unsecured source and a short-term or a long-term source depending on the period.
• A Debenture is an instrument issued by a company in acknowledgement of a loan taken by it, and it carries a fixed rate of interest payable to the holder, so the debenture holder is a creditor of the company and not an owner, and the debenture is a long-term unsecured source.
• A Preference share carries a fixed rate of dividend, and a preference as to the payment of the dividend over the ordinary shares, and the holders do not have a voting right in the ordinary business, so it is a long-term source.
• An Equity share is the ordinary share, and the holder has a right to vote, a right to the remaining profit after the payment of the preference dividend, and a right to the assets on the winding up, so it carries a risk and a higher return.
• Issue of Rights shares: the shares are offered to the existing shareholders in proportion to their existing holdings, so the firm raises the capital without the delay and the cost of a public issue, and the firm keeps its control in the hands of the existing shareholders.

The second axis of the classification is the period for which the finance is required, and it is the axis that actually determines the source used in practice, because a firm would never buy machinery with a one year overdraft, since the finance would have to be repaid long before the machine had earned its own cost.

• Short-term finance is required for a period of up to one year, and it is needed to meet the day to day requirement of the working capital, and the sources are the trade credit, the bank loan, the bank overdraft, the discount of the bills, the public deposit, the factoring and the internal source of the retained profit.
• Medium-term finance is required for a period of more than one year and up to five years, and it is needed for the working capital requirement of a firm in some cases and for the purchase of the fixed assets like the plant and machinery, and the sources are the term loan from the bank, the loan from the financial institutions and the public deposit taken for a medium period.
• Long-term finance is required for a period of more than five years, and it is used for the fixed assets and for the long term growth and the expansion, and the sources are the debenture, the long-term bank loan, the public issue of the shares and the rights issue, and the venture capital for a firm that is not listed.
• Short-term finance is the cheapest, but it must be renewed at the end of the period and the renewal is never certain, and this is its one disadvantage.
• Long-term finance is the most expensive, but it does not have to be renewed and the firm can plan for a long period, and this is the exchange for the higher cost.

Several sources do not fit neatly into the deposit, loan and share groups, and the syllabus lists them separately. They are examinable, and the venture capital item in particular has a definition the examiner expects exactly.

• Factoring is a source of short-term finance in which a firm sells its receivables to a factor at a discount, so the firm receives the money immediately and the factor collects from the debtor, and the cost is the discount plus the interest charged by the factor.
• Leasing: a firm obtains the use of an asset by paying a rent for a fixed period without owning it, and the lease is a medium-term or a long-term source, and it is useful for an asset that becomes obsolete quickly, such as the computer equipment.
• Venture capital is a source of long-term finance provided by the venture capital funds to a growing company, normally a small or a medium one, in exchange for an equity share or a convertible debenture, and it is used by the firms that cannot go to the public market because they are too small or too new.
• The problem with the venture capital is that the fund usually takes a large share in the ownership, so the founder loses the control of the firm, and if the firm is successful the fund's share in the profit is very large.
• The Electronic Stock Trading and the Depository Receipts: a Global Depository Receipt is an instrument issued by a company to a non-resident investor, through an authorised depository bank, so that the shares of an Indian company can be traded on an overseas exchange, and it is a source of foreign capital, while an American Depository Receipt is the same instrument issued specifically for the trading on the American stock exchange.
• The commercial paper, the securitisation and the venture capital funds are the newer sources, and the answer to a question on the recent trends in the sources of finance is that the finance is increasingly raised from the financial market rather than from a bank.

The last part of the chapter is the applied part, and it expects a list of factors with a sentence of explanation each, so a three-mark answer is three factors and a five-mark answer is five.

• The nature of the business: a trading business needs a large working capital for a short period, so it prefers the trade credit, while a manufacturing business needs a large capital for a long period and prefers the debenture or the shares.
• The size of the business: a large firm can go to the public market and issue the shares, while a small firm must depend on the owner's contribution, the retained profit and the bank loan, because the public issue is beyond it.
• The cost of the source: the internal source is the cheapest, the short-term external source is next, and the equity and the debenture are the most expensive, so a firm with a good profit record and a low risk will prefer the cheaper source.
• The period for which the finance is needed: the short-term need is met by the short-term source, and the long-term need by the long-term source, and this is the single most reliable rule in the chapter.
• The state of the economy: in a period of inflation the interest rates are high, so the cost of every external source rises, and in a period of easy money the finance becomes cheaper and the firm can borrow for a longer period.
• The legal requirements and the control of the firm: a firm that does not wish to lose the control to a new shareholder will avoid the issue of the equity shares and use a debenture or a bank loan instead.

The last part of the chapter is the comparison of the two groups, and it is the most frequently asked three-mark question in the chapter, so the points are worth writing out as a table in the notes.

• Source: the internal source comes from the business itself, such as the retained profit and the sale of the assets, while the external source comes from outside the business, such as the bank, the public, the government and the financial market.
• Cost: the internal source is the cheapest because there is no interest and no issue cost, while the external source is comparatively expensive because the interest, the dividend and the fee of the issue have to be paid.
• Risk: the internal source is the safest for the firm because there is no obligation of repayment to a third party and so there is no financial risk, while the external source carries the risk of the fixed payment whether or not the firm has earned the profit in that year.
• Control: the internal source does not affect the control of the firm at all, while the issue of the shares brings in a new shareholder whose vote may change the balance of the control.
• Amount: the internal source is limited in amount and is not suitable for a large or a fast growing firm, while the external source is available in a large amount and is capable of meeting a requirement that is beyond the capacity of the business.
• Period: the internal source is generally a permanent source, while the external source is available in the short, the medium and the long term, so a firm can choose the period that matches the purpose of the finance.
• The conclusion of the comparison: no firm can be financed by the internal source alone, so the practical choice is a balance between the internal and the external, and the answer to a question asking which is better is that the internal source should be used to the extent it is available and the external source should meet the balance of the requirement.