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NCERT Class 11 Business Studies Chapter 8 Sources of Business Finance
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Sources of Business Finance
Chapter: 8
| PART – ⅠⅠ |
| EXERCISES |
Short Answer Questions:
1. What is business finance? Why do businesses need funds? Explain.
Ans: The requirements of funds by business to carry out its various activities is called business finance. Finance required by business to establish and run its operations is known as business finance. No business can function without adequate funds for undertaking various activities.
Businesses need finance for three reasons mainly: To purchase plants and machinery, land, buildings and other fixed assets. Finance can help Businesses for multiple purposes.For setting up a business, fixed assets such as building, machinery, furniture, and fixtures are required.
2. List sources of raising long-term and short-term finance.
Ans: 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.
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.
3. What is the difference between internal and external sources of raising funds? Explain.
Ans:
| Internal Source | External Source |
| Internal sources of funds are those that are generated from within the business. | Another basis of categorising the sources of funds can be whether the funds are generated from within the organisation or from external sources. |
| The internal sources of funds can fulfil only limited needs of the business. | External sources of funds include those sources that lie outside an organisation, such as suppliers, lenders, and investors. |
| Internal sources are less costly than the external funds. | External funds may be costly as compared to those raised through internal sources. |
4. What preferential rights are enjoyed by preference shareholders. Explain.
Ans: 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.
(ii) receiving their capital after the claims of the company’s creditors have been settled, at the time of liquidation.
5. Name any three special financial institutions and state their objectives.
Ans: The three financial institutions which their objective are as:
(i) Industrial Development Bank of India: The Industrial Development Bank of India (IDBI) is a financial institution that provides financial support to businesses.
(a) The collaboration with institutions operating in the banking sector for the expected growth of the industrial sector.
(b) Their main aim is to promote industrial growth and serve the public rather than profit. Their financial assistance is provided to the private and public sectors.
(ii) National Bank for Agriculture and Rural Development: It is a prominent financial institution in India with a specific focus on the development of agriculture and rural areas.
(a) NABARD is a Development Bank with a mandate for providing and regulating credit for the development of agriculture, small-scale industries.
(b) Focus on developing rural economies by giving credit and other financial services to small farmers, artisans, and rural entrepreneurs.”
(iii) Small Industries Development Bank of India: The Small Industries Development Bank of India (SIDBI) is a key financial institution in India that plays a crucial role in promoting and developing small-scale and medium enterprises.
(a) The main objective of SIDBI is to offer loans to MSMEs to help in addressing the development and financial gaps in the ecosystem of MSMEs.
(b) Developing human resources through training and skill up gradation of small entrepreneurs as well as its own manpower.
6. What is the difference between GDR and ADR? Explain
Ans:
| GDR | ADR |
| The depository the bank issues depository receipts against these shares. Such depository receipts denominated in US dollars are known as Global Depository Receipts (GDR). | The depository receipts issued by a company in the USA are known as American Depository Receipts. |
| GDR is a negotiable instrument and can be traded freely like any other security. | ADRs are bought and sold in American markets, like regular stocks. |
| A holder of GDR can at any time convert it into the number of shares it represents. | 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 the USA. |
Long Answer Questions
1. Explain trade credit and bank credit as sources of short-term finance for business enterprises.
Ans: 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 short term financing. It is granted to those customers who have a 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.
The important merits of trade credit are as follows:
(i) Trade credit is a convenient and continuous source of funds.
(ii) Trade credit may be readily available in case the credit worthiness of the customers is known to the seller.
(iii) Trade credit needs to promote the sales of an organisation.
(iv) If an organisation wants to increase its inventory level in order to meet expected rise in the sales volume in the near future, it may use trade credit to finance the same.
(v) It does not create any charge on the assets of the firm while providing funds.
Bank credit: 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.
The merits of raising funds from a commercial bank are as follows:
(i) Banks provide timely assistance to business by providing funds as and when needed by it.
(ii) Secrecy o f business can be maintained as the information supplied to the bank by the borrowers is kept confidential.
(iii) Formalities such as issue of prospectus and underwriting are not required for raising loans from a bank. This, therefore, is an easier source of funds.
(iv) Loan from a bank is a flexible source of finance as the loan amount can be increased according to business needs and can be repaid in advance when funds are not needed.
2. Discuss the sources from which a large industrial enterprise can raise capital for financing modernisation and expansion.
Ans: A brief description of various sources is given below:
(i) 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’.
(ii) 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 short term financing.
(iii) Factoring: It is a financial service under which the ‘factor’ renders various services which includes:
(a) Discounting of bills 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.
(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 records.
(iv) 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’.
(v) 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.
(vi) 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.
(vii) 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. These are equity shares and preference shares.
(viii) 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 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.
(ix) 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.
(x) Financial Institutions: The government has established a number of financial institutions all over the country to provide finance to business organisations. 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.
3. What advantages does the issue of debentures provide over the issue of equity shares?
Ans: 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 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. Equity shares are 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.
The merits of raising funds through debentures are given as follows:
(i) It is preferred by investors who want fixed income at lesser risk.
(ii) Debentures are fixed charge funds and do not participate in profits of the company.
(iii) The issue of debentures is suitable in the situation when the sales and earnings are relatively stable.
(iv) As debentures do not carry voting rights, financing through debentures does not dilute control of equity shareholders on management.
(v) Financing through debentures is less costly as compared to cost of preference or equity capital as the interest payment on debentures is tax deductible.
4. State the merits and demerits of public deposits and retained earnings as methods of business finance.
Ans: 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 business.
The merits of public deposits are:
(i) The procedure of obtaining deposits is simple and does not contain restrictive conditions as are generally there in a loan agreement.
(ii) Cost of public deposits is generally lower than the cost of borrowings from banks and financial institutions.
(iii) Public deposits do not usually create any charge on the assets of the company. The assets can be used as security for raising loans from other sources.
(iv) As the depositors do not have voting rights, the control of the company is not diluted.
The major limitation of public deposits are as follows:
(i) New companies generally find it difficult to raise funds through public deposits.
(ii) It is an unreliable source of finance as the public may not respond when the company needs money.
(iii) Collection of public deposits may prove difficult, particularly when the size of deposits required is large.
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 organisation.
The merits of retained earning as a source of finance are as follows:
(i) Retained earnings is a permanent source of funds available to an organisation.
(ii) It does not involve any explicit cost in the form of interest, dividend or floatation cost.
(iii) As the funds are generated internally, there is a greater degree of operational freedom and flexibility.
(iv) It enhances the capacity of the business to absorb unexpected losses.
(v) It may lead to an increase in the market price of the equity shares of a company.
Retained earning as a source of funds has the following limitations:
(i) Excessive ploughing back may cause dissatisfaction amongst the shareholders as they would get lower dividends.
(ii) It is an uncertain source of funds as the profits of business are fluctuating.
(iii) The opportunity cost associated with these funds is not recognised by many firms. This may lead to suboptimal use of the funds.
