CBSE Class 11 Business Studies Chapter 7 Notes: Sources of Business Finance

Class 11 Business Studies Chapter 7 Notes (Sources of Business Finance)

As a Class 11 Business Studies student, do you ever wonder how these big companies have such large capital to run their operations?

Well, you are thinking right!

With our comprehensive Class 11 Business Studies Chapter 7 notes on the Sources of Business Finance, you can learn about the following:

The fundamental differences between fixed and working capital requirements

Classification of funds

The strategic merits and limitations of retained earnings, trade credit, equity shares, preference shares, and debentures

Before you proceed further, below are the quick details:

• Class: 11
• Subject: Business Studies
• Chapter Number: 7
• Chapter Name: Sources of Business Finance

Table of Contents

Concept of Business	Retained Earnings
Trade Credit	Types of Issue of Shares
Debentures

Concept of Business

Business is concerned with the production and distribution of goods and services for the satisfaction of the needs of society. For carrying out various activities, business requires finance. Therefore, it is the lifeblood of any business. The requirement of funds by a business to carry out its various activities is called business finance.

Types of Financial Requirements of a Business

Fixed Capital Requirements

In order to start a business, funds are required to purchase fixed assets like land and building, plant and machinery, and furniture and fixtures. These funds are known as fixed capital requirements of the enterprise. These funds remain invested in the business for a long period of time. The requirement of fixed capital may be different for different kinds of businesses. A trading enterprise may require a small amount of fixed capital as compared to a manufacturing enterprise.

Working Capital Requirements

These are the funds required for the day-to-day operations of the business. These funds are invested in the business for a shorter period of time. They are used for holding current assets such as stock of materials and bills receivables and for meeting current expenses like salaries, wages, taxes and rent. A trading firm requires more working capital as compared to a manufacturing concern.

Sources of Funds Classification

On the Basis of Period

Long-term

• Equity shares
• Retained earnings
• Preference shares
• Debentures
• Loans from financial institutions
• Loans from banks

Short-term

• Trade credit
• Factoring
• Banks
• Commercial paper

Medium-term

• Loans from banks
• Public deposits
• Loans from financial institutions
• Lease financing

On the Basis of Ownership

Owner's Funds

• Equity share capital
• Retained earnings

Borrowed Funds

• Debentures
• Loans from banks
• Loans from financial institutions
• Public deposits
• Lease financing
• Commercial paper

On the Basis of Source of Generation

Internal Sources

• Equity share capital
• Retained earnings

External Sources

• Financial institutions
• Loans from banks
• Preference shares
• Public deposits
• Debentures
• Lease financing
• Commercial paper
• Trade credit
• Factoring

Classification of Sources of Funds

On the Basis of Period

The different sources can be categorized into three parts:

Short-term Funds

• These funds are required for a period not exceeding one year.
• For example: trade credit, loans from commercial banks and commercial papers.

Medium-term Funds

• These funds are required for a period of more than one year but less than five years.
• These sources include borrowings from commercial banks, public deposits, lease financing and loans from financial institutions.

Long-term Funds

• Long-term sources fulfil the financial requirements of an enterprise for a period exceeding five years.
• These include sources such as shares and debentures, long-term borrowings and loans from financial institutions.

On the Basis of Ownership

On the basis of ownership, the sources can be classified into two parts:

Owner's Funds

• Owner's funds mean funds that are provided by the owners of an enterprise.
• They remain invested in the business for a longer duration and are not required to be refunded during the life of the business.
• The two important sources of owner's funds are:
  1. Equity shares
  2. Retained earnings

Borrowed Funds

• These funds are raised through loans and borrowings. These sources provide funds for a specific 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, which are provided on the security of some fixed assets.
• These include loans from commercial banks, loans from financial institutions, issue of debentures, public deposits and trade credit.

On the Basis of Generation

On the basis of generation, funds are classified as:

Internal Sources

• Internal sources of funds are those that are generated from within the business.
• A business can generate funds internally by:
  1. Disposing of surplus inventories
  2. Retained earnings

External Sources

• External sources of funds include those sources that lie outside an organization. They may be costly compared with funds raised through internal sources.
• These include issuing debentures, borrowing from commercial banks and financial institutions, and accepting public deposits.

Retained Earnings

Retained earnings refer to a part of the profit which is not distributed among the shareholders as dividends but is retained in the business for use in the future. It is a source of internal financing or self-financing and it is also known as “Ploughing Back of Profits”.

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

Limitations of Retained Earnings It is an uncertain source of funds as the profits of business are fluctuating. Excessive ploughing back may cause dissatisfaction among the shareholders as they would get lower dividends.

Trade Credit

Trade credit is the credit extended by one trader to another for the purchase of goods and services. It appears in the records of the buyer of goods as ‘Sundry Creditors’ or ‘Accounts Payable’. It is commonly used as a source of short-term financing by business organizations. It is granted to customers who have a reasonable amount of financial standing and goodwill.

Merits of Trade Credit Trade credit is a convenient and continuous source of funds. It may be readily available in case the creditworthiness of the customers is known to the seller. It does not create any charge on the assets of the firm while providing funds. It helps promote the sales of an organization.

Limitations of Trade Credit Availability of easy and flexible trade credit facilities may induce a firm to indulge in overtrading, which may add to the risks of the firm. Only a limited amount of funds can be generated through trade credit. It is generally a costly source of funds as compared to most other sources of raising money.

Types of Issue of Shares

The capital obtained by the issue of shares is known as ‘Share Capital’. The capital of a company is divided into small units called ‘Shares’. Each share has its own nominal value. The person holding the share is known as a ‘Shareholder’.

There are two types of shares:

• Equity Shares
• Preference shares

The money raised by issue of equity shares is called equity share capital. The money raised by issue of preference shares is called preference share capital.

Equity Shares

• Equity shares are the most important source of raising long-term capital by a company. Equity shares represent the ownership of the company.
• Equity shareholders do not get a fixed dividend but are paid on the basis of earnings by the company. They are the residual owners of the company and enjoy the reward as well as bear the risk of ownership.
• Their liability is limited to the extent of the company. These shareholders have a right to participate in the management of the company.

Merits of Equity Shares Equity shares are suitable for investors who are willing to assume risk for higher returns. Payment of dividend to the equity shareholders is not compulsory. Therefore, it does not create any burden on the company. Equity capital serves as permanent capital as it is to be repaid only at the time of liquidation of a company. It provides creditworthiness to the company and confidence to prospective loan providers. Democratic control over management of the company is assured due to voting rights of equity shareholders.

Limitations of Equity Shares Investors who want steady income may not prefer equity shares as equity shares get fluctuating returns. The cost of equity shares is generally more as compared to other sources. Formalities and procedural delays are involved while raising funds through issue of equity shares. Issue of additional equity shares dilutes the voting power and earnings of existing equity shareholders.

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:
• Receiving a fixed rate of dividend before any dividend is declared for equity shareholders.
• Receiving their capital after the claims of the company's creditors have been settled, at the time of liquidation.

Merits of Preference Shares Preference shares provide reasonably steady income in the form of fixed rate of return and safety of investment. These are useful for those investors who want fixed rate of return with comparatively low risk. It does not affect the control of equity shareholders over the management as preference shareholders do not have voting rights. Preference capital does not create any sort of charge against the assets of a company.

Limitations of Preference Shares Preference shares are not suitable for those investors who are willing to take risk and are interested in higher returns. Preference capital dilutes the claims of equity shareholders over assets of the company. The dividend paid is not deductible from profits as expense. Thus, there are no tax savings as in the case of interest on loans. The rate of dividend on preference shares is higher than the rate of interest on debentures.

Various Types of Preference Shares

Cumulative and Non-Cumulative Preference Shares	The preference shares which enjoy the right to accumulate unpaid dividends in the future years, in case the same is not paid during a year, are known as cumulative preference shares. Non-cumulative shares are those shares in which dividend is not accumulated if it is not paid in a particular year.
Participating and Non-Participating Preference Shares	Preference shares which have a right to participate in the further surplus of a company after dividend at a certain rate has been paid on equity shares are called participating preference shares. The non-participating preference shares are those which do not enjoy such rights of participation in the profits of the company.
Convertible and Non-Convertible Preference Shares	Preference shares that can be converted into equity shares within a specific period of time are known as convertible preference shares. Non-convertible shares are such that they cannot be converted into equity shares.

Differences between Equity Shares and Preference Shares

Basis	Equity Shares	Preference Shares
Face Value	The face value of equity shares is generally low.	The face value of preference shares is generally high.
Risk	The equity shareholders are the primary risk bearers.	The risk involved in preference shares is relatively less.
Dividend	Equity shareholders are given dividends depending upon the profits of the company.	Preference shareholders get a fixed rate of dividend.
Refund of Capital	At the time of winding up of the company, equity shareholders are refunded only after preference shareholders are paid.	At the time of winding up, preference shareholders get priority over equity shareholders for the refund of capital.
Payment of Dividend	Equity shareholders are given dividends after the settlement of preference shareholders' claims.	Preference shareholders are entitled to dividend after the settlement of outsiders’ liabilities but before dividend to equity shareholders.
Voting Rights	Equity shareholders get all the voting rights in the company.	In normal conditions, no voting rights are provided, but if the dividend is not paid for two years or there is any decision which affects them directly, they get voting rights.

Debentures

Debentures are an important instrument for raising long-term debt capital. A company can raise funds through the issue of debentures, which bear a fixed rate of interest. The debenture issued by a company is an acknowledgement that the company has borrowed a certain amount of money, which it promises to repay at a future date. Debenture holders are termed as creditors of the company.

Merits of Debentures It is preferred by investors who want fixed income at lesser risk. Debentures are fixed charge funds and do not participate in the profits of the company. The issue of debentures is suitable in situations where the sales and earnings are stable. Financing through debentures is less costly as compared to the cost of preference or equity capital.

Limitations of Debentures As fixed charge instruments, debentures put a permanent burden on the earnings of a company. Each company has a certain borrowing capacity to further borrow funds, which reduces. In the case of redeemable debentures, the company has to make provisions for repayment on the specified date.

Types of Debentures

First and Second Debentures	Debentures that are repaid before other debentures are repaid are known as first debentures. The Second debentures are those which are paid after the first debentures.
Secured and Unsecured Debentures	Secured debentures are those debentures which create a charge on the assets of the company. Unsecured debentures are those debentures which do not carry any charge or security against the assets of the company.
Registered and Bearer Debentures	Registered debentures are those which are duly recorded in the register of debenture holders maintained by the company. Bearer debentures are those debentures which are transferable by mere delivery.
Convertible and Non-convertible Debentures	Convertible debentures are those debentures that can be converted into equity shares after the expiry of a specific period. Non-convertible debentures are those debentures which cannot be converted into equity shares.

The End

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A List of Notes:

Chapter 1  |  Chapter 2  |  Chapter 3  |  Chapter 4  |  Chapter 5  |  Chapter 6  |  Chapter 7  |  Chapter 8  |  Chapter 9  |  Chapter 10

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