Chapter 8

Sources of Business Finance

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4. Sources of Finance

The primary source of business finance is the investment by the owner. Funds from loans are the secondary source of finance. In a sole proprietorship business finance mainly comes from the owner’s personal savings. Part of the profit is reinvested over a period of time and additional funds are borrowed on the personal guarantee of the assets of the business. Financing in partnership business is also done in almost similar way. Initial investment comes from the partners and further finance is added from creditors.

When joint stock companies are set up, promoters can invite the public to invest in the capital of the company as share holders. When the promoters already are reputed, raising large funds is relatively easy. Banks and other financial institutions finance business projects on large scale. During expansion stage, more investments will be made by redirecting profits into business.

To sum up, there are two basic sources of funds. The first source is owners’ funds and the second is the borrowed funds.

Owners’ funds or ownership capital

There is a difference between funds and capital. Capital is the money originally invested the profits invested subsequently. Funds include capital and all other sources of finance from the owners. For example, partner’s loan is owner’s fund not the owner’s capital. Following are the features of owner’s funds:

(i)      Provision of risk capital: Owners’ fund is the source of risk capital in the business. It is the owners who bear the risk in a business. When money is invested from loan, the creditors for these loans have first claim if the business goes into difficulty. Owners can get back whatever is left after settling all the outside claims. However, in times of prosperity owners get more the benefit. Thus the fortunes of owners are directly linked to the prosperity or otherwise of the business.

(ii)    Permanent Source of Capital: Owner’s capital is the permanent source of capital in a business. Creditors or loans have to be paid back after a certain period. This is the only finance that can be safely invested in fixed assets, because the fixed assets and meant for long term use in a business.

(iii)  Separation of Ownership and Management: This is a feature of company, where owners are shareholders who do not directly manage business like sole proprietorship or partnership. Management policies are guided by the Board of Directors who which is the body of elected representatives of the shareholders. Day to day affairs are carried out by officers who are employees of the company.

(iv)   No Security Required: Ownership capital does not involve any security or charge on the properties of the business. In fact there is no scope of such a condition, since the owners are ultimately responsible for the liabilities of the business.

Merits

(i)       Ownership capital provides the risk capital which is the basis for further loans or borrowed capital in the business. If the owners’ capital investment is higher, the creditors have less risk in giving loans to the business.

(ii)     Since the ownership capital is non refundable, until the business is permanently closed down.  It can be utilized for investing in fixed assets of the business. It is a safe source of finance. Even if the business does not make any revenue for some time, the owner’s capital would not make additional burden in the form of interest or claims for repayment.

(iii)    In a joint stock company capital invested in the form of shares gives right to control the business. Directors are elected by shareholders whose voting rights are determined by the number of shares held.

(iv)   Since no security is required for the ownership capital, the assets of the company can be utilized for raising loan capital.

(v)     A reputed company can raise unlimited amount of capital. This helps further development in the form of generating goods and employment opportunity.

Limitations

(i)       Diffusion of Power: A joint stock company can raise unlimited capital, which will reduce the control and power of the original promoters

(ii)     Underutilization of Ownership funds: Being permanent source of funds without any burden of repayment or interest claim, the owner’s funds can be underutilized in a business.

Borrowed Funds or Borrowed Capital

Borrowed fund includes all sources of funds way of credit. The main characteristics are:

(i)      Time Bound: Borrowed capital is time bound. It has to be paid back at a certain time. It may be short term, medium term, or long term depending on the period allowed before repayment.

(ii)    Need for Security: Loans are generally granted on the security of properties of the business. Limited amounts of loans can be raised on the personal guarantee of owners. But most creditors insist on tangible security on the loans given.

(iii)  Repayment: Loans are always meant for repayment. Loans are not permanent measures of finance. The creditor needs his money back at the end of the agreed term of loan. The original amount of loan and the liability arising out of the interest on such loan are to be paid irrespective of whether the business made any profit or not. There are exceptional cases where the creditors may agree to keep the loan for indefinite term. However all loans have preferential right to refund in the event of liquidation of the business, over the refund of capital.

(iv)   Control: Creditors hardly have any control over the decisions over the business. They can sue the firm for the default in payment of interest or repayment of the loan amount. The creditors can take over the assets mortgaged for the loan through legal proceedings only.

Merits

From the point of view of a business borrowed capital has the following advantages:

(i)       It does not affect the owners control over the management of the business.

(ii)     Interest is an expense of the business. It can be charged in the profit and loss account. The tax liability is reduced.

(iii)    It provides flexibility in business. Loans can be raised when the need arises and it can be repaid back as soon as there is enough cash. Thus the business need not carry the burden of underutilized excess capital.

(iv)    There rate of interest is fixed. When the business generates high rate of return on the investment, this factor works very much in favour of the owner.

Limitations

(i)       Fixed Liability: Loan and interest on loan are liabilities of the business. They must be paid off even if the business fails to generate adequate cash. Failure to pay the outsiders liabilities will create more difficult situations on account of legal proceedings.

(ii)     Security of Assets: When loans are raised on the security of assets of the business, the owner loses freedom to dispose of the assets even when there are compelling reasons to do so.

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