Need for business finance
Business finance means the money a business needs to start, run and grow. Without money, no work can begin.
Why money is needed
- Fixed capital: money for things kept for many years, like land, building, machines and furniture. It is needed at the start and is usually large.
- Working capital: money for daily running, like raw material, wages, electricity, rent and stock. Goods are sold, cash comes back, and it is used again.
- Growth: to open new branches, buy new technology and do research.
- Bad times: to face a fall in sales or a sudden loss.
The money needed depends on the size of the business, its kind (a factory needs more fixed capital than a shop) and how fast it wants to grow.
Owners' funds
Owners' funds (owned capital) are the money put in by the owners plus profit kept back. It need not be returned while the business runs, and no fixed return has to be paid. Owners carry the risk and have control.
Equity shares
A company divides its capital into small parts called shares. Equity shareholders are the real owners. They vote in meetings, get a dividend only when there is profit and after preference holders, and are paid last if the company closes. Merit: permanent money, no burden in a loss year. Limit: control gets shared and issuing shares takes time and cost.
Preference shares
Preference shareholders get two preferences: a fixed rate of dividend before equity holders, and their capital back before equity holders when the company closes. They usually cannot vote. Good for careful investors who want a steady return. Kinds include cumulative (unpaid dividend carries forward), redeemable (money returned after a time) and convertible (can change into equity).
Retained earnings
A company does not pay out all its profit. The part it keeps and reinvests is retained earnings (ploughing back of profit). Merit: no cost, no outsider, no paperwork, owners' control unchanged. Limit: amount is uncertain because profit changes; shareholders may be unhappy with low dividend.
Borrowed funds: long term
Borrowed funds come from outsiders. They must be repaid after a fixed time, with interest, even if the business makes a loss. Lenders do not get control, but they usually want a security (asset as a guarantee).
Debentures and bonds
A debenture is a written promise by a company that it has borrowed money and will repay it on a date with fixed interest. Debenture holders are creditors, not owners. Bonds work the same way and are often issued by government bodies and big companies. Merit: interest is a business expense (saves tax) and control stays with owners. Limit: fixed interest burden and risk of losing pledged assets.
Loans from commercial banks
Banks give term loans and cash credit for short, medium and long periods, usually against security. Quick and private, but banks ask for many papers and may put conditions.
Loans from financial institutions
Special institutions (like IFCI, SIDBI, NABARD, state finance corporations) give long-term money for new projects and expansion, often with advice. Useful when banks will not lend for so long, but the process is slow.
Borrowed funds: short term
Public deposits
A company asks the public to deposit money with it directly, usually for up to 3 years. It pays a little more interest than a bank savings deposit, and the company pays less than a bank loan would cost. Simple, but it depends on public trust and has legal limits.
Trade credit
A supplier gives goods now and allows payment later (for example 30 or 60 days). It is shown as creditors or bills payable. Merit: no formal process, helps working capital. Limit: may push the firm to overbuy, and only a limited amount is available.
Inter-corporate deposits (ICDs)
Unsecured short-term deposits that one company with extra cash makes with another company. Periods can be as short as a day (call deposits), three months or six months. Quick and informal, but interest can be high.
How to choose a source
- Cost: retained earnings cost nothing; equity is costly to issue.
- Risk: more borrowing means fixed interest even in a loss.
- Control: new equity shares control; debt does not.
- Period: long-term needs with long-term money, short-term needs with short-term money.
Key formulas and definitions
- Business finance = Owners' funds + Borrowed funds
- Owners' funds = Equity share capital + Preference share capital + Retained earnings
- Long term: equity, preference, retained earnings, debentures/bonds, long-term loans
- Short term: trade credit, public deposits (up to 3 yrs), ICDs, bank cash credit
- Interest on debt = Borrowed amount × rate (paid even in loss)
Worked examples
1. A company needs ₹50 lakh. It raises ₹30 lakh by equity and ₹20 lakh by 10% debentures. What must it pay every year even if there is a loss?
Only the debenture interest is compulsory: 20 lakh × 10% = ₹2 lakh a year. Equity dividend is paid only if there is profit and the board declares it.
2. Classify: (a) machines worth ₹10 lakh, (b) raw material for this month, (c) wages. Fixed or working capital?
(a) Fixed capital (used for many years). (b) and (c) Working capital (daily running needs).
3. A supplier sends cloth worth ₹80,000 to a tailor and asks for payment after 45 days. Which source of finance is this?
Trade credit: goods now, payment later, from a supplier.
4. A company earned ₹10 crore profit. It paid ₹4 crore as dividend. How much are retained earnings this year, and why is this a cheap source?
₹10 crore − ₹4 crore = ₹6 crore kept back. It is cheap because no interest, no issue cost and no new owners are involved.
5. Why would a company with a very steady income be happy to issue debentures rather than new equity shares?
Steady income means it can easily pay fixed interest. Debentures do not share control or profit, and interest is a tax-deductible expense, so owners gain more.
Common mistakes
- Calling debenture holders owners. They are creditors (lenders); shareholders are owners.
- Thinking preference shareholders always get a vote. Usually they vote only on matters affecting their own rights.
- Treating retained earnings as borrowed money. It is the owners' own profit kept back, so it is an owners' fund.
- Using short-term money (trade credit) to buy long-term assets like machines. Match the period of the need with the period of the source.