Meaning and significance of business finance: Finance required by business to establish and run its operations is known as business finance. No business can function without adequate amount of funds for undertaking various activities.
The funds are required for purchasing fixed assets (fixed capital requirement), for running day-to-day operations (working capital requirement), and for undertaking growth and expansion plans in a business organisation.
Classification of sources of funds: Various sources of funds available to a business can be classified according to three major basis, which are (i) time period (long, medium and short term), (ii) ownership (owner’s funds and borrowed funds), and (iii) source of generation (internal sources and external sources).
Long, medium and short-term sources of funds: The sources that provide funds for a period exceeding 5 years are called long-term sources. The sources that fulfill the financial requirements for the period of more than one year but not exceeding 5 years are called medium term sources and the sources that provide funds for a period not exceeding one year are termed as short term sources.
Owner’s funds and borrowed funds: Owner’s funds refer to the funds that are provided by the owners of an enterprise. Borrowed capital, on the other hand, refers to the funds that are generated through loans or borrowings from other individuals or institutions.
Internal and external sources: Internal sources of capital are those sources that are generated within the business say through ploughing back of profits. External sources of capital, on the other hand are those that are outside the business such as finance provided by suppliers, lenders, and investors.
Sources of business finance: The sources of funds available to a business include retained earnings, trade credit, factoring, lease financing, public deposits, commercial paper, issue of shares and debentures, loans from commercial banks, financial institutions and international sources of finance.
Retained earnings: The portion of the net earnings of the company that is not distributed as dividends is known as retained earnings. The amount of retained earnings available depends on the dividend policy of the company. It is generally used for growth and expansion of the company.
Trade credit: The credit extended by one trader to another for purchasing goods or services is known as trade credit. Trade credit facilitates the purchase of supplies on credit. The terms of trade credit vary from one industry to another and are specified on the invoice. Small and new firms are usually more dependent on trade credit, as they find it relatively difficult to obtain funds from other sources.
Factoring: Factoring has emerged as a popular source of short-term funds in recent years. It is a financial service whereby the factor is responsible for all credit control and debt collection from the buyer and provides protection against any bad-debt losses to the firm. There are two methods of factoring - recourse and non-recourse factoring.
Lease financing: A lease is a contractual agreement whereby the owner of an asset (lessor) grants the right to use the asset to the other party (lessee). The lessor charges a periodic payment for renting of an asset for some specified period called lease rent.
Public deposits: A company can raise funds by inviting the public to deposit their savings with their company. Pubic deposits may take care of both long and short-term financial requirements of business. Rate of interest on deposits is usually higher than that offered by banks and other financial institutions.
Commercial paper (CP): It is an unsecured promissory note issued by a firm to raise funds for a short period The maturity period of commercial paper usually ranges from 90 days to 364 days. Being unsecured, only firms having good credit rating can issue the CP and its regulation comes under the purview of the Reserve Bank of India.
Issue of equity shares: Equity shares represents the ownership capital of a company. Due to their fluctuating earnings, equity shareholders are called risk bearers of the company. These shareholders enjoy higher returns during prosperity and have a say in the management of a company, through exercising their voting rights.
Issue of preference shares: These shares provide a preferential right to the shareholders with respect to payment of earnings and the repayment of capital. Investors who prefer steady income without undertaking higher risks prefer these shares. A company can issue different types of preference shares.
Issue of debentures: Debenture represents the loan capital of a company and the holders of debentures are the creditors. These are the fixed charged funds that carry a fixed rate of interest. The issue of debentures is suitable in the situation when the sales and earnings of the company are relatively stable.
Commercial banks: Banks provide short and medium-term loans to firms of all sizes. The loan is repaid either in lump sum or in instalments. The rate of interest charged by a bank depends upon factors including the characteristics of the borrowing firm and the level of interest rates in the economy.
Financial institutions: Both central and state governments have established a number of financial institutions all over the country to provide industrial finance to companies engaged in business. They are also called development banks. This source of financing is considered suitable when large funds are required for expansion, reorganisation and modernisation of the enterprise.
International financing: With liberalisation and globalisation of the economy, Indian companies have started generating funds from international markets. The international sources from where the funds can be procured include foreign currency loans from commercial banks, financial assistance provided by international agencies and development banks, and issue of financial instruments (GDRs/ ADRs/ FCCBs) in international capital markets.
Factors affecting choice: An effective appraisal of various sources must be instituted by the business to achieve its main objectives. The selection of a source of business finance depends on factors such as cost, financial strength, risk profile, tax benefits and flexibility of obtaining funds. These factors should be analysed together while making the decision for the choice of an appropriate source of funds.