Every business, whether small or large, requires funds to start and grow. Business finance refers to the money required to establish, operate, and expand a business. Choosing the right source of finance is a critical decision for any business owner.
---
Need for Business Finance
- Setting up fixed assets (land, machinery, buildings)
- Meeting day-to-day working capital needs
- Research and development
- Expansion and diversification
---
Classification of Sources of Finance
Sources of finance are classified on three bases:
- 1. Based on Period:
- Short-term (up to 1 year): Trade credit, bank overdraft, commercial paper
- Medium-term (1-5 years): Bank loans, hire purchase, leasing
- Long-term (more than 5 years): Equity shares, debentures, retained earnings
- 2. Based on Ownership:
- Owned funds: Equity shares, preference shares, retained earnings
- Borrowed funds: Debentures, bank loans, public deposits
- 3. Based on Source:
- Internal sources: Retained earnings, depreciation funds
- External sources: Share capital, loans, public deposits
---
Key Sources Explained
Equity Shares:
Owners of equity shares are the real owners of the company. They get a dividend only if profits exist, and they bear the highest risk but get voting rights.
Sunita buys 1,000 equity shares of Bright Ltd. at Rs. 100 each. She is now a part-owner, gets dividends when declared, and can vote at AGMs. If the company goes bankrupt, she loses her investment but nothing more.
---
Preference Shares:
These carry a fixed rate of dividend and are paid before equity shareholders. They usually do not carry voting rights.
Mohan holds preference shares with a 10% dividend. Even if profits are low, Mohan receives his 10% before equity holders get anything. This makes preference shares less risky than equity.
---
Debentures:
Debentures are long-term debt instruments. The holder is a creditor, not an owner. Interest is paid at a fixed rate regardless of profit.
ABC Ltd. issues debentures at 12% per annum. Mr. Sharma, the debenture holder, receives Rs. 1,200 annually per Rs. 10,000 debenture regardless of whether the company made profit or loss.
---
Retained Earnings:
The portion of profit kept within the business instead of distributing it as dividends. Also called ploughing back of profits.
XYZ Ltd. earns Rs. 50 lakhs profit in a year. It distributes Rs. 30 lakhs as dividends and retains Rs. 20 lakhs for future expansion. This Rs. 20 lakhs is retained earnings — an internal, cost-free source of finance.
---
Public Deposits:
Companies invite deposits from the public for 6 months to 3 years. The rate of interest is higher than bank savings but the investor bears the credit risk.
Priya deposits Rs. 1 lakh with Sunrise Manufactures Ltd. for 2 years at 9% interest per annum. She earns Rs. 9,000 per year. The company uses this as medium-term finance.
---
Bank Loans and Overdraft:
Banks provide short-term and medium-term loans. An overdraft allows businesses to withdraw more than their account balance up to a sanctioned limit.
A textile firm needs Rs. 5 lakhs urgently to buy raw material. It uses a bank overdraft facility to cover this temporary shortfall and repays when customers pay their dues.
---
Trade Credit
When a supplier allows a buyer to purchase goods now and pay later (e.g., 30/60/90 days), it is called trade credit. It is the most common source of short-term finance. No interest is charged if paid within the credit period.
Ravi buys goods worth Rs. 2 lakhs from a supplier on 45-day credit. This Rs. 2 lakhs is effectively free short-term finance for 45 days.
---
Comparison: Owned vs. Borrowed Funds
| Feature | Owned Funds | Borrowed Funds |
|---|---|---|
| Repayment | Not required | Must be repaid |
| Interest/Dividend | No fixed obligation | Fixed interest |
| Risk | Owner bears risk | Lender protected |
| Control | Owner has voting rights | Lender has no say |
---
Common mistakes
- Confusing debenture holders with shareholders — debenture holders are creditors, not owners.
- Thinking retained earnings have no cost — they have an opportunity cost.
- Believing public deposits are risk-free for investors — they carry credit risk.
---
Summary
Business finance is the lifeblood of any enterprise. Sources range from equity and preference shares to debentures, retained earnings, public deposits, and bank loans. The choice of source depends on cost, risk, control, and the duration of the fund requirement.