Basic Concepts, Forms and

Financing of Business UNIT 4 METHODS OF RAISING FINANCE

Structure
4.0 Objectives
4.1 Introduction
4.2 Need for and Importance of Finance
4.3 Types of Financial Needs
4.3.1 Fixed Capital and Working Capital
4.3.2 Long-term Capital and Short-term Capital
4.4 Capital Structure
4.4.1 Ownership Capital
4.4.2 Borrowed Capital
4.4.3 What is Capital Structure?
4.5 Methods of Raising Capital
4.5.1 Issue of Shares
4.5.2 Issue of Debentures
4.5.3 Loans from Financial Institutions
4.5.4 Loans from Commercial Banks
4.5.5 Public Deposits
4.5.6 Retention of Profits
4.5.7 Trade Credits
4.5.8 Factoring
4.5.9 Discounting Bills of Exchange
4.5.10 Bank Overdraft and Cash Credit
4.6 Let Us Sum Up
4.7 Key Words
4.8 Some Useful Books
4.9 Answers to Check Your Progress
4.10 Questions for Practice

4.0 OBJECTIVES
After going through this Unit, you will be able to:

explain the need for finance

classify types of financial needs
distinguish between ownership capital and borrowed capital
explain the concept of capital structure and identify the factors determining
it
describe different methods of raising finance
evaluate the advantages and limitations of different methods of raising
finance

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 Methods of Raising Finance
4.1 INTRODUCTION
In the previous Units you have learnt about the nature of business activities, the
types of business in which individuals may be engaged, and the different forms
in which business activities may be organised. You know that adequate capital
is necessary for financing various activities of the business, and, therefore, raising
of finance is a pre-requisite for setting up any business unit. No one can start a
business unless adequate capital is available. In this Unit you will learn why
finance is needed, what the sources of finance are and the methods of raising
finance to meet capital requirements of the business.

4.2 NEED FOR AND IMPORTANCE OF FINANCE

We all know that every business activity requires money to run it. Take the case
of manufacturers. They must have a place to produce goods. They must buy
machinery and raw materials, engage workers and managers, pay for electricity
and water supply, and incur expenses for delivery of goods to their customers.
Similarly, take the case of traders. They must buy goods and have godown to
keep them. They have to arrange for the delivery of the goods to their customers.
They must employ people for loading and unloading of goods, for keeping
accounts as well as for bill collection. Take another example of goods
transportation business. The transporters must buy trucks, must engage drivers
and helpers, incur expenses on diesel, repairs and servicing of the vehicle, and
so on. All these can be undertaken only with the help of finance. Thus, money is
required for all types of business activities, be it manufacturing or trading or
transportation or any other kind. It is true that income is earned by business
when goods are sold and services have been rendered. But this takes place
afterwards. Goods must be produced or purchased before they can be earned. It
costs money to build a factory, to buy machinery and raw materials, to hire a
place for the business office, to pay rent, wages and salaries, and to meet day to
day expenses. So no one can run a business without first raising adequate finance,
of course, this is done in anticipation of future income, on the assumption that
customers will buy the goods and services offered to them.

To run a business, besides finance, we also require men, materials, machinery

and management. But finance may be regarded as the most important
requirements of business. Men, materials, machinery and managers can be
brought together and engaged in business when you have adequate finance.
Many business firms are known to have failed mainly due to shortage of finance.
The importance of finance has increased in modern times for two reasons. Firstly,
the business activities are now undertaken on a much larger scale than in the
past. Even if a business is started initially on a small scale, it grows in course of
time. There is increasing need for finance with enlargement of business. Secondly,
the manufacturing processes have become more complex than in the past. Factory
production requires expensive machinery, equipment and tools, and many men.
It requires large quantities of material to be procured and kept in stock. The
products must be widely advertised. Distribution of the products must be arranged
through wholesalers, dealers and salesmen. Thus, with the growth in size and
volume of business and with the increasing complexity of production and trade,
there is a growing need for finance. In an existing business on the one hand,
money must be spent before money is realised from sales. On the other hand,
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Basic Concepts, Forms and cash realization on account of sales over a certain period may not be equal to the
Financing of Business
amount of expenditure incurred during the same period. Finance should, therefore,
be available in adequate amount as and when needed. To anticipate what amount
of finance will have to be arranged at what point of time is not an easy task. This
is because business conditions may change from time to time.

4.3 TYPES OF FINANCIAL NEEDS

Broadly speaking, there are two ways of classifying the financial needs of the
business. I) On the basis of the extent of permanence, we can classify the financial
needs into: a) fixed capital, and b) working capital. Ii) On the basis of the period
of use, we can classify the financial needs into: a) long-term capital, and b)
short-term capital. Look at Figure 4.1 for the classification of financial needs.

Financial Needs

Based on Permanence Based on Period of Use

Fixed Capital WorkingCapital Long-term Short-term

Capital Capital

Figure 4.1:Classification of Financial Needs

4.3.1 Fixed Capital and Working Capital

Fixed Capital: In every business concern money has to be invested in some
fixed or durable assets like land, buildings, machinery, equipment, furniture,
etc. These assets are required for permanent use, that is, for a long period of
time. Funds required to purchase these assets is known as fixed capital or long-
term capital. The nature and size of the business generally determines the amount
of fixed capital needed. Manufacturing activities, particularly those engaged in
heavy engineering, electrical, transport, shipping and ship building, electric
supply, iron and steel manufacture, automobiles, etc. require large investments
in plant and machinery, equipment, factory buildings, warehouses, etc. On the
other hand, trading concerns need relatively lesser investment in fixed assets.

Investment in fixed assets involves a commitment for a longer period of time.

These fixed assets continue to generate income and profits over an extended
period of time. Moreover, funds which are once invested in fixed assets cannot
be withdrawn and put to some other use.

Working Capital: In business you require finance for purchase of raw material,
payment of wages and salaries, rent, fuel, electricity and water, repairs and
maintenance of machinery, advertising, etc. Requirements of finance for these
purposes arise at short intervals. In course of business activities, it is also
necessary to hold stocks of materials, spare parts, and finished goods. This
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involves investment in short-term assets or current assets in the form of stocks Methods of Raising Finance
of raw materials, spare parts, stores, finished goods, etc. Besides, sale of goods
on credits leads to the holding of debtors balances and bills receivable, which
may also be regarded as current assets.

Money invested in current assets like stock of raw materials, finished goods,
etc., and book debts (that is debtors balances as well as bills receivable) is known
as Working Capital. It is sometimes known as Circulating Capital or
Revolving Capital. That is because fund invested in current assets are
continuously recovered through realization of cash, and again reinvested in
current assets. The amount keeps on circulating or revolving from cash to current
assets and back again to cash. Although this takes place at short intervals, the
amount is needed again and gain. Hence part of the funds required for this purpose
is of a permanent nature. It is known as the ‘fixed or permanent’ part of the
working capital. The permanent part of working capital should accordingly be
regarded as long term capital. The other part of working capital may vary due to
the rise or fall in the volume of business. Hence it is known as the ‘fluctuating’
or ‘variable’ part of the working capital. Therefore, strictly speaking, only the
fluctuating part of the working capital is regarded as short-term capital, the funds
required are for less than a year. The amount of working capital required depends
mainly on the nature of the business, the time required for completing the
manufacturing process, and the terms on which materials are purchased and
goods are sold. For instance, trading companies require more working capital
than manufacturing companies. This is because the trading business requires
large quantities of goods to be held in stock, and also carry large debtors’ balances.
Construction companies also require relatively larger amounts of working capital
than manufacturing concerns. In both these types of business, the value of current
assets is relatively smaller in the case of hotels and restaurants because they
mostly have cash sales, and only small amount of debtors balances.

Working capital requirements vary among manufacturing industries because of

differences in the time involved in the production process i.e., time that passes
between the purchase of raw materials and the production of finished goods.
Longer the processing time, the more is the amount of working capital required.
For example, heavy engineering industry needs relatively more working capital
than a rice mill or a cotton spinning mill or a steel rolling mill.

Another factor that determines the amount of working capital relates to the terms
of credit allowed to customers. For instance, a company may allow only 15
days’ credit, while another may allow 90 days’ credit. One may extend credit
facilities liberally to all customers, while another in the same business may
grant credit only to selected reliable customers. The amount of working capital
required will naturally be more if the credit period is longer and credit facilities
are extended to all customers. In both these cases, there will be larger debtors’
balance which will demand more working capital. On the other hand, if supplies
of materials are available on favourable terms of credit (i.e., payments can be
made at longer intervals), working capital needs will be correspondingly smaller.

4.3.2 Long-term Capital and Short-term Capital

As stated earlier, fixed assets should be financed with permanent long-term
capital. This is mainly because fixed assets are meant for use over a fairly long
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Basic Concepts, Forms and period of time, generally for five years or more. Long term capital is also required
Financing of Business
to finance the permanent part of the working capital. On the other hand, to finance
current assets and meeting day-to-day expenses, capital is needed generally for
a short period i.e., less than a year. This is because stocks of materials and finished
goods are normally used or sold within a year, and dues from customers are
usually realised within three to six month. The main difference between long-
term capital and short-term capital is that the former is required for a longer
period, (five years or more) while the latter is required for a short period (less
than a year). Besides these capital needs, business concerns often require funds
for a period of 2 to 5 years known as medium-term capital. Medium-term capital
is required for certain activities like renovation of building, modernisation of
machinery, heavy expenditure on advertising, etc.

4.4 CAPITAL STRUCTURE

The fund raised to meet both the long-term and short-term capital requirements
may take the form of ownership capital or borrowed capital. Let us first
understand these two terms before we talk of capital structure.

4.4.1 Ownership Capital

The amount of capital invested in a business by its owners is known as
Ownership Capital. It is on the basis of their investment that owners become
entitled to the profits of the business. In a business under sole proprietorship,
the individual owner normally invests capital from his own savings. In a
partnership business, each partner contributes capital as mutually agreed among
partners. Companies raise capital by issuing shares. Investors who contribute
towards the share capital of a company become its owners by virtue of their
share holding. They are entitled to receive dividend out of the profits earned by
the company. The owners cannot claim to get any return on their investment
unless there is profit. The rate of return on owners investment depends on the
level of profits earned. It there is no profit, the owners go without any dividend.
The risk of losses and of low rates of return are, thus, associated with ownership
capital. Hence it is known as ‘risk capital’.

Ownership capital may be used for financing fixed assets as well as continuous
investment in current assets. Ownership capital is generally used as permanent
capital or long-term capital. As risk-bearers, owners do not have any assurance
whether they will get adequate returns on their investment or not. But they receive
high returns if the business is successful. Besides, owners have a right to
participate in the management of the business. A sole proprietor as also the
partners of a business play an active part in running the business. Shareholders
of companies do not manage the business directly. They elect members of the
Board of Directors who manage the affairs of the company on behalf of the
shareholders.

4.4.2 Borrowed Capital

The financial requirements of the business are often met by raising loans. Loans
carry a certain fixed rate of interest which must be paid at regular intervals, half
yearly or yearly. There is also a commitment that the principal amount will be
repaid in due course. Thus, if loan is raised for a period of 10, 15 or 20 years, its
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repayment may fall due at the end of that period or after stated intervals according Methods of Raising Finance
to the terms on which the loan has been raised. Interest on loan is a fixed expense
which has to be paid irrespective of the income. Thus, borrowing of money
involves fixed obligation to pay interest and repay the principal amount as and
when due.

Money may be borrowed for short-term and long-term purposes i.e., to finance
fixed assets as well as current assets. In a sole proprietory business the proprietor
can borrow money on his personal security or on the security of his existing
assets. A partnership firm can raise loans on the personal security of the individual
partners whereby they become jointly and severally liable. Companies can also
borrow either by issuing debentures or bonds, or raise direct loans.

If business income is stable and cash is realised from debtors regularly, rising of
loan is not difficult. But if conditions are such that payment of interest is not
possible as and when due, serious consequences may follow. There is loss of
credit worthiness, that is, suppliers may not be prepared any more to supply
materials on credit, further loans may not be forthcoming and lenders and
creditors may even start legal action to recover their dues. Hence, borrowing
money without the ability to meet the obligations of paying interest and repaying
the principal is not desirable.

However, there are certain advantages of financing business activities with loans.
If the business is profitable, interest being fixed charge, the return on owners’
investment is much higher. Suppose total investment in a business is Rs. 1 lakh
out of which owners have contributed Rs. 40,000 and loans have been raised for
the balance of Rs. 60,000 at 15% interest per annum. The profit earned during
the year is Rs. 30,000. In this case, the total amount of interest payable is Rs.
9,000. So profits after interest payment will amount to Rs. 21,000. Let us assume
that tax is payable on profits at the rate of 50%. So tax to be paid amounts to Rs.
10,500. Net profit after tax will thus be Rs. 10,500. What will be the return on
owner’s capital? It will be Rs. 10,500 on their investment of Rs. 40,000 that is
26.25%. Would it be so high if the owners had invested Rs. 1 lakh and there was
no borrowing? Obviously not. Let us examine. Since no interest would be
payable, tax would amount to Rs. 15,000 (50% of Rs. 30,000). The net profit
after tax would amount to Rs. 15,000 (total profit of Rs. 30,000 minus Rs. 15,000
tax). The return on owners’ capital would then be Rs. 15,000 on an investment
of Rs.1 lakh which works out to only 15%. You must have realised that owners
got a higher rate of return when a part of the total investment was borrowed. If
you examine all this carefully, you can notice two effects. Firstly, the amount of
tax payable was less (Rs. 10,500 instead of Rs. 15,000). Secondly, the payment
on account of interest was fixed. Although loans helped in the expansion of
business, nothing more was to be paid to lenders. The remaining profit was
entirely for the owners. Use of borrowed capital to derive the remaining profit
was entirely for the owners. Use of borrowed capital to derive the benefit of
higher rates of return on owners’ investment is known as ‘Trading on Equity’.

4.4.3 What is Capital Structure?

You have noticed that borrowing is desirable when profits are high. But it may
be dangerous to depend on loans when profits decline. Then what should be the
amount of borrowing for financing business activities? The general principle is
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Basic Concepts, Forms and to maintain borrowed capital and owners’ capital in proper proportions. For a
Financing of Business
very successful business in favourable conditions, borrowed capital may be twice
or even thrice as large as owners’ investment. But for a business which is suffering
from declining profits, the proportion of borrowed capital should be as low as
possible.

Since borrowing of funds has distinct advantages, you may expect promoters to
raise as large an amount as possible through loans. But beyond a certain limit
borrowing may be risky. This is because fluctuation in earning and inadequacy
of available cash could lead to a situation where it may not be possible for the
business to pay interest and repay the amount of loan. In that case, the financial
position of the business is sure to be looked upon by suppliers and creditors as
unreliable. They may stop extending credit, and in an extreme situation, the
business may go bankrupt or insolvent. This danger arises basically on account
of the fixed payments to be made on borrowed capital irrespective of the earnings
and the shortage of available cash.

The proportion of fixed interest bearing capital in the total capital is known as
capital gearing. The capital is, thus, said to be highly geared if borrowed capital
is proportionately very high in relation to the ownership capital. Correspondingly,
low gearing of capital signifies a smaller proportion of borrowed capital compared
with the ownership capital. The composition of the total capital consisting partly
of long-tern funds with fixed charge and partly of ownership funds is known as
the capital structure. Thus, capital structure refers to the relative proportion in
which various sources of long-term finance are used to meet the total financial
requirements, like debentures and long-term loans, preference share capital, and
equity capital (including reserves and surplus).
Check Your Progress A
1) State which of the following statements are True or False.
i) There is increasing need for finance in business only because workers
always demand higher wages.
ii) No one can run a business without finance.
iii) Fixed capital is required to finance the purchase of raw materials.
iv) Relatively more fixed capital is required by manufacturing companies
than trading companies.
v) Long-term investment is required for financing fixed assets as well as
current assets.
vi) High gearing of capital indicates more of debt financing.
vii) The permanent part of working capital may be regarded as long-term
finance.
viii) Working capital is not required by traders who buy and sell goods on
credit.
ix) In a profitable business, the return on owners’ capital will be more if
part of the total is borrowed.
2) Fill in the blanks with appropriate works.
i) Ownership capital is also known as .................. capital.
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 ii) ..................... capital is sometimes called revolving or circulating Methods of Raising Finance
capital.
iii) Funds required for 5 years or more is regarded as .................. finance.
iv) Short-term finance is required for a period upto ..................... years.
v) Medium-term finance is required for a period of ............... years.
vi) Trading companies need more working capital than ................. capital.
vii) Investment in current assets generally means .................. investment.
viii) Loans may be raised for long-term as well as .................. purposes.
3) Match the items in Column A with those in Column B.
Column A Column B
1) Fixed capital i) Current assets
2) Long-term finance ii) Short-term finance
3) Medium-term finance ii) Risk capital
4) Capital structure iv) Durable assets
5) Working capital v) More than 5 years
6) Ownership capital vi) Modernisation of machinery
7) Bills receivable vii) Borrowed capital and equity capital

4.5 METHODS OF RAISING CAPITAL

You have learnt that there are different purposes for which funds have to be
raised for periods ranging from very short to fairly long duration. The size and
nature of business determine the total amount of financial needs. The scope of
raising funds depends on the sources from which funds may be available. For a
sole proprietor, there are limited opportunities for raising funds. He can finance
his business by any of the following means:
1) Investment of own savings
2) Raising loans from friends and relatives
3) Arranging advances from commercial banks
4) Borrowing from finance companies
The same methods of financing are available to partnership firms also. In both
these forms of business organisations, long-term capital is generally provided
by the owners, i.e., sole proprietor or the partners.

Fixed capital can be raised by way of loans from friends and relatives on the
personal security of owners. Generally short-term working capital needs are
met partly by trade creditors (suppliers of materials and goods) and loans from
finance companies. Another method of securing both long and short-term finance
is the reinvestment of profits earned from time to time.

In the case of companies, there are a number of methods of raising finance. To

raise long-term and medium-term capital, companies have the following options:
1) Issue of shares
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Basic Concepts, Forms and 2) Issue of debentures
Financing of Business
3) Loans from financial institutions
4. Loans from commercial banks
5) Public deposits
6) Retention of profits
The following methods may be used to finance short-term capital:
1) Trades credit
2) Factoring
3) Discounting bills of exchange
4) Bank overdraft and cash credit
5) Public deposits
Look at Figure 4.2 for various methods adopted by companies for raising finance.

Methods of Raising Finance

Long-term Capital Medium-term Capital Short-term Capital

Bank
Equity Preference Bank Public Discounting Over-
Debentures Retention Trade Factoring
Shares Shares Loans Deposits Bills of Draft &
of Profits Credit Exchange Cash
Credit

Figure 4.2 Methods of Raising Finance by Companies

Note: 1. Public deposit could be used for both medium-term as well as short-term purposes.
2. Retention of profits could be used for both Long-term as well as short-term capital purposes.

4.5.1 Issue of Shares

Issue of shares is the most important method of raising long-term capital for
companies. There are two types of shares: i) equity shares and ii) preference
shares. In the case of share, the liability of shareholders is limited to the face
value of shares, and also they are easily transferable. For these reasons investors
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prefer to invest their money in shares. Moreover, shares issued are generally of Methods of Raising Finance
small face value viz., Rs.10 or Rs.100 so investment in shares is within the
means of ordinary people. As you know, a private company cannot invite the
general public to subscribe for its share capital. Private companies can issue
share to a limited number of persons not exceeding fifty. Also share of private
companies are not freely transferable. But for public limited companies there
are no such restrictions.

Equity shares: There are several advantages of issuing equity shares to raise
ownership capital. The rate of dividend on these shares depends on profits
available and the discretion of directors. There is, therefore, no fixed burden on
the company. The shareholders expect high rates of dividend in profitable years.
But they also bear the high risk associated with uncertainty of earnings of the
company. Thus risk capital is available by issuing these shares. Further, the
amount raised by issue of equity shares can be used permanently. It is not required
to be paid back so long as the company exists. Moreover, equity share do not
require mortgaging of the company’s assets. Additional funds can be raise as
loan on the security of assets.

However, excessive issue of equity shares may create problems for the promoters
who may like to control the management of the company. Each equity share
carries one vote for the holder. So holders of equity shares may form groups and
vote against the existing directors of the company. This may not be always in
the best interest of the company as a whole. Secondly exclusive dependence on
equity share capital may not permit the company to take advantage of trading on
equity. Besides, once equity share are issued the amount become a permanent
capital which at times may be more than what the company can use profitably.
In that case, there is no way of reducing it unless detailed legal formalities are
complied with. Also reduction of share capital damages the image of the company.

Preference shares: Issue of preference shares is another method of raising long-

term capital. It has certain merits. Dividend is payable on preference shares at a
fixed rate and is payable only if there are profits. Hence, there is no compulsory
burden on the company’s finances. Secondly, preference shareholders do not
have voting right. So they cannot take part in the management of the company
and thus are not a threat to the promoters. Another advantage of preference
shares is that the company can declare higher rates of dividend for equity
shareholders in good years because the rate of preference dividend is fixed.
Besides, permanent use of preference share capital is also not essential. A
company may issue redeemable preference shares and have the flexibility of
paying off the amount if necessary and replace it by some other type of capital.

Some investors subscribe to preference shares because of preferential rights as

to the payment of dividend and the return of capital. But others do not prefer it
due to the fixed return as well as some risk of non-payment of dividend. Also
they do not derive any benefit by way of rise in market price of the shares as is
the case with equity shares.

4.5.2 Issue of Debentures

Companies generally have powers to borrow and raise loans by issuing debentures
as securities of specified face value. The rate of interest payable on debentures
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Basic Concepts, Forms and is fixed at the time of issue, and they are recovered by a charge on the property
Financing of Business
or assets of the company, which provide the necessary security for payment.
Debentures are mostly issued to finance the long-term requirements of business.
There are certain advantages of issuing debentures.

i) Because of the fixed interest on debentures, companies with stable income

can secure higher returns on equity capital by trading on equity.

ii) The rate of interest is usually lower than the expected rate of return on
share capital. This is because debenture holders do not bear any risk.

iii) Debentures do not carry any voting right. Hence management by promoters
or existing directors remains unaffected.

However, if the earnings of the company are uncertain or unpredictable, issue of

debentures may pose serious problems for the company due to the fixed obligation
to pay interest and repay the principle. The company is liable to pay interest
even if there is no profit. If there is default in payment of interest or repayment
of the principle, assets can be attached by order of the court. Trading companies
which generally do not have large fixed assets cannot provide adequate security
for issue of debentures. Even for manufacturing companies the capacity to raise
loans is limited by value of their properties and assets.

5.5.3 Loans from Financial Institutions

Long-term and medium-term loans can be secured by companies from financial
institution like the Industrial Finance Corporation of India, Industrial Credit
and Investment Corporation, State-level Industrial Development Corporation,
etc. These financial institutions grant loans for a maximum period of 25 years
against approved schemes or projects. Loans agreed to be sanctioned must be
covered by securities by way of mortgage of the company’s property or
hypothecation or assignment of stocks, shares, gold, etc.

Usually the financial institutions nominate one or two directors to have some
degree of control over the functioning of the company. These nominee directors
may not allow decisions to be made by the Board of Director affecting the interest
of the lending institution. The loan agreement may also provide for conversion
of loans into equity capital after a stated period if the lending institution so
desires.

The most important advantage of this method of raising finance is that the rate
of interest payable is lower than market rate. But there is a close security of the
investment project before loans is sanctioned. The potential profitability of the
project and the potential ability of the company to discharge its interest and
repayment obligations are strictly evaluated. Also the companies are required to
comply with a number of legal and technical formalities. Hence a long time is
taken in the process of negotiating a loan from the financial institutions.

5.5.4 Loans from Commercial Banks

Medium-term loans can be raised by companies from commercial banks against
the security of properties and assets. Thus, funds required for modernisation
and renovation of assets can be borrowed from banks. Generally 50% to 75% of
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the value of industrial assets is granted as loan after the bank is satisfied about Methods of Raising Finance
the earning capacity of the company and its ability to generate sufficient cash
flows. The bank does not require any legal formality except that of creating a
mortgage on the assets. Besides, the loan can be repaid in parts and interest
saved to that extent. Short-term loans can also be obtained from banks on the
personnel security of the directors of the company. These are known as clean
advances.

5.5.5 Public Deposits

Companies often find it convenient and necessary to raise funds by inviting
their shareholders, employees and the general public to deposit their saving
with the company. The Companies Act permits such deposits to be received for
a period up to 3 years at a time. Thus, public deposits can be a raised by companies
to meet their short-term and medium –term financial needs. It is a simple method
of raising finance for which the company has only to advertise in the newspapers
giving particulars about its financial position as prescribed by the Companies
Act. The deposits are not required to be covered by mortgaging assets or by
other securities. Moreover deposits can be invited by offering a higher rate of
interest than the interest on bank deposits. But companies are not permitted to
raise unlimited amounts of fund through public deposits.
5.5.6 Retention of profits
Profitable companies do not generally distribute the whole amount of profits as
dividend. A certain proportion is transferred to reserves and utilised as additional
capital. Thus the financial needs of a company can be met by retaining a part of
the annual profits. This may be regarded as reinvestment of profits or ‘ploughing
back of profits’. Since retained profits actually belong to the shareholders of
the company, these are treated as a part of ownership capital, and may be used to
meet long medium and short-term financial needs. The main advantage is that
there is no legal formality involved, nor does the company have to depend on
external investors to raise capital. Retention of profit is a sort of self financing
of business. However, only the on-going profitable companies can make use of
this source of finance. For profitable companies transfer up to 10% of current
profits is legally permitted. A company may transfer more than 10% of profits to
reserves provided it fulfils certain conditions laid down in the rules framed under
the companies Act. In short, more than 10% of current profits can be retained
only after declaring a minimum rate of dividend consistent with the dividend
distributed in the past.
5.5.7 Trade Credit
Just as companies sell goods on credit, they also buy raw materials, components,
stores and spare parts on credit from different suppliers. Hence, outstanding
amounts payable to trade creditors as well as bills payable relating to credit
purchases are regarded as sources of finance. Generally suppliers grant credit
for a period of 3 to 6 months, and thus provide short-term finance to the company.
Availability of this type of finance is closely connected with the volume of
business. When the production and sale of goods increase, there is automatic
increase in the volume of purchases, and more of trade credit is available. On
the other hand, if sales decline there is a corresponding decline in purchases of
materials, and consequent decline in trade credit as a source of finance. Thus

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Basic Concepts, Forms and creditors, balances (account payable) and bills payable help companies to finance
Financing of Business
current assets, i.e., stock of materials and finished goods as well as book debts.
However, trade credit also involves loss of cash discount which could be earned
if payments were made within 7 to 10 days from the date of purchase. This loss
is regarded as the cost of trade credit.

5.5.8 Factoring
The amounts due to a company from customers on account of credit sale generally
remain outstanding during the period of credit allowed i.e. till the dues are
collected from the debtors. If necessary, book debts may be assigned to bank
and cash realised in advance from the bank. By this arrangement the responsibility
of collecting the debtors’ balances is taken over by the bank on payment of
specified charges by the company. This is a method of raising short-term capital
and known as ‘factoring’. It helps companies to secure finance against debtors’
balances before the debts are due for realisation, and incidentally also helps in
saving the effort of collecting the book debts. The bank charges payable for the
purpose is treated as the cost of raising funds. Keeping in view the risk of bad
debts, the amount to be made available by banks is calculated so as to provide
for a margin for non-realisation of debts. The disadvantage of factoring is that
customers who are in genuine difficulty do not get the facility of delaying payment
which they might have otherwise got from the company.

5.5.9 Discounting Bills of Exchange

This method is widely used by companies for raising short-term finance. When
goods are sold on credit, bills of exchange are generally drawn for acceptance
by the buyers of goods. The bills so drawn are payable after 3 or 6 months
depending on the prevailing practice among traders. Instead of holding the bills
till the date of maturity, companies generally prefer to discount them with
commercial banks on payment of a charge known as bank discount. Bills are
endorsed in favor of the bank so as to enable it to realise the amount of the bill
on maturity from concerned parties. The amount of discount is deducted from
the value of bills at the time of discounting. The rate of discount to be charged
by banks is prescribed by the Reserve Bank of India from time to time. It really
amounts to the interest for the period from the date of discounting to the date of
maturity of the bill. If any bill is dishonored on maturity, the bank returns it to
the company which then becomes liable to pay the amount to the bank. The cost
of raising finance by this method is the discount charged by the bank.

4.5.10 Bank Overdraft and Credit

Arranging cash credit and overdraft with commercial banks is a common method
adopted by companies for meeting short-term financial requirements. Cash credit
refers to an arrangement on a continuing basis whereby the commercial bank
allows money to be drawn as advance from time to time within a specified limit
known as cash credit limit. This facility is granted against the security of goods
in stock, or promissory notes bearing a second signature, or other marketable
instruments like government bonds. The company is allowed to draw whatever
amount is required at different times within the limit agreed upon. The cash
credit limit may be revised according to the value of securities. The money
drawn can be repaid as and when possible. Interest is charged on the actual
amount withdrawn.
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Overdraft is a temporary arrangement with the bank which permits the company Methods of Raising Finance
to overdraw from its current deposit account with the bank upto a certain limit.
The overdraft facility is also granted against securities as in the case of cash
credit. Interest is charged on the actual amount overdrawn.
The rate of interest charged on cash credit and overdraft is relatively much higher
than the rate of interest on bank deposits. But this method of financing has the
flexibility of allowing funds to be drawn for short-term purposes according to
changing needs which depend on business conditions.
Check Your Progress B
1) Six methods of raising finance are mentioned below. Indicate by tick marks
the methods which can be used for raising fixed capital.
i) Issue of equity shares
ii) Clean advance from banks
iii) Public deposits
iv) Loans from financial institutions
v) Discounting of bills
vi) Issue of preference shares
2 Which of the following methods can be used by a company for raising
short-term finance? Put a tick mark against those methods only.
i) Issue of debentures
ii) Cash credit
iii) Public deposit
iv) Bank overdraft
v) Term loans from banks
3) Read the following statements and indicate which of them are True or False.
i) ‘Trading on equity’ is possible if a company issues preference shares
and debentures for raising necessary capital.
ii) Fixed capital can be raised by issuing preference shares.
iii) Factoring means appointing a bank as collecting agent.
iv) Equity shares capital can be used for investment in fixed assets as
well as current assets.
v) Bills of exchange can be discounted with a bank on payment of interest
in advance.
vi) Any amount of public deposits can be raised by a company.
vii) Issue of debentures must be covered by adequate security of assets.
viii) Cash credit is just like clean advance from banks.
ix) Term loans can be raised from commercial banks for long term
purposes.

x) Trade credit helps in financing short-term investments.

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Basic Concepts, Forms and 4 Fill in the blanks with appropriate words selected from the words given in
Financing of Business
the brackets.
i) Equity shares are issued for ……… (investment in fixed assets,
financing operating expenses, modernisation of plants)
ii) Short term working capital is generally raised from ……….. (fixed
assets, goods in stock bank balance)
iii) Cash credit is granted against the security of ………….. (fixed assets,
goods in stock, bank balance)
iv) The cost of trade credit is………. ( loss of profit, loss of cash discount,
loss of interest)
v) Amount due from customers on account of credit sale requires
…………….. financing. (long-term medium term, short term)

4.6 LET US SUM UP

Every business firm requires money or finance to run its activities. The importance
of finance has increased in modern times for two reasons: (i) business activities
are now undertaken on a much larger scale than in the past, and (ii) manufacturing
processes have become more complex than before.

Broadly speaking, the financial requirements of a business are of two types: i)

fixed capital and ii) working capital. Finance required to purchase fixed assets
is known as fixed capital or long–term capital. Finance needed for investment in
current assets is known as working capital or circulating capital. The nature of
business and size of the business unit generally determine that amount of fixed
capital needed. On the other hand, the amount of working capital depends upon
the nature of business, the time required for completing the manufacturing
process, and the terms on which materials are purchased or goods are sold.
Funds raised to meet the financial requirements of a business can be classified
as ownership capital and borrowed capital. The amount of capital invested in a
business by its owners (proprietor, partners or shareholders) is known as
ownership capital. Borrowed capital may be raised by way of direct loans, or by
issue of debentures or bonds in the case of a company. Ownership capital is
raised by companies by issuing shares. Borrowed capital is often used to drive
the benefit of higher rates of return on owners’ investment. This is known as
‘trading on equity’.
‘Capital structure’ refers to the relative proportion in which different sources of
long-term finance is used to meet the total requirements. The proportion of fixed
interest bearing capital in the total capital is known as ‘capital gearing’.
The main difference between long-term finance and short-term finance is that
the former is required for use over a longer period, five years or more, while the
later is required for a short period of less than a year. Finance required for a
period of 2 to 5 years is known as medium-term finance.
Sole proprietorship concerns and partnership firms have limited opportunities
of financing their business. They can use one or more of the following methods
of raising funds: investment of own savings, raising loans from friends and
relatives, advance from commercial banks and borrowings from finance
76 companies, all against personal security or against the security of their own
assets and properties. Methods of Raising Finance

A company may decide to use one or more of the following methods to meet the
needs of long-term and medium-term finance: issue of shares, issue of debentures,
loans from financial institutions, loans from commercial banks, public deposits
and retention of profits.
To raise short-term finance, a company may use trade credits, factoring,
discounting bills of exchange, arranging bank overdraft and cash credits, and
raising public deposits. Each of these methods has certain advantages as well as
disadvantages.

4.7 KEY WORKS

Borrowed Capital: Fund raised by way of loans or issue of debentures, which
entitle the investors (i.e. lenders) to claim regular payment of interest and
repayment of the loan when due.
Capital Gearing: The proportion of fixed interest-bearing capital in the total
capital of a business.
Capital Structure: Proportion in which different sources of long-term finance
are used to meet the total funds requirement, like shares, debentures, loans,
retained profits, etc.
Factoring: Assignment of book debts to a bank and receiving cash in advance
with the responsibility of collecting the debts taken over by the bank on payment
of specified charges.
Fixed Capital: Funds required for purchase of fixed assets like land, building,
plant and machinery, furniture, etc.
Long-term Finance: Finance required for use over a long period, five years or
more, meant for purchase of fixed assets and continuous investment in a part of
the current assets.
Medium-term Finance: Fund required for use over a period of 2 to 5 years,
generally for renovation of building, modernisation of plant and machinery, etc.
Ownership Capital: Funds invested by owners of business for permanent use,
which entitle then to decide how the business activities will be managed and
what will be their share in the profits.
Public Deposits: Deposits raised from the public for medium or short-term
financial needs.
Short-term Finance: Funds required for short periods, less than a year, meant
for financing current assets which fluctuate due to changing volume of business.
Trade Credit: Outstanding amounts payable to suppliers of raw materials and
consumable items and bills payable relating to credit purchases.
Trading on Equity: Use of borrowed capital to have a higher rate of return on
equity capital.
Morking Capital: Funds required for holding current assets like stock of raw
materials, finished goods, book debts, bills receivable, etc.
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Basic Concepts, Forms and
Financing of Business 4.8 SOME USEFUL BOOKS
Bhushan, Y.K. 1987. Fundamentals of Business Organisation and Management,
Sultan Chand & Sons: New Delhi. (Part 8, Chapters 1 & 2)
Kuchhal, S.C. Corporation Finance, Chaitanya Publishing House: Allahabad.
Paish, F.W. 1975. Business Finance, Pitman: London (Chapters 1-3) Singh, B.P.
and T.N. Chhabra. 1988. Business Organisation & Management, Kitab Mahal:
Allahabad. (Chapters 16 & 17).

4.9 ANSWERS TO CHECK YOUR PROGRESS

A 1) i) False ii) True iii) False iv) True
v) True vi) True vii) True viii) False ix) True
2) i) Fixed ii) working iii) Long-term iv) One
v) 25 vi) Fixed vii) Short-term viii) Short-term
3) 1) iv) 2) v 3) vi 4) vii 5) ii 6) iii 7) i
B 1) i, iv, vi
2) ii, iii, iv
3) i) False ii) Trueiii) False iv) True v) True
vi) False vii) True viii) False ix) False x) True
4) i) investment in fixed assets
ii) commercial banks
iii) goods in stock
iv) iv) loss of cash discount
v) short-term finance

4.10 QUESTIONS FOR PRACTICE

1) Discuss briefly the importance of finance in business. Distinguish between
fixed capital and working capital.
2) State the purposes for which working capital is required. Discuss the factors
determining working capital needs.
3) What are the advantages of raising capital through borrowings?
4) What is meant by ownership capital? What are its merits and limitations?
5) State the methods of raising fixed capital.
6) What are the methods of raising short-term capital? Discuss.
7) Briefly explain the merits and demerits of issuing debentures. Compare it
with equity shares as a method of raising fixed capital.
8) Compare the relative advantages and disadvantages of issuing equity shares
and preference shares.
9) What are the advantages of raising finance through public deposits? What
are the legal requirements to be fulfilled for raising public deposits?
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10) Discuss briefly ‘factoring’ and ‘discounting of bills of exchange’ as methods Methods of Raising Finance
of raising short-term finance
11) What do you understand by overdraft and cash credit facilities? Mention
the types of securities required for cash credit and overdraft.
12) What is meant by capital structure? What factors should management take
into account while deciding on a capital structure?

Note: These questions will help you to understand the unit better. Try to
write answers for them. But do not send answers to the university.
They are for your practice.

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