Hello Readers,
My name is Nikitha, and I'm an Analyst in Luxoft BNPP India Calypso BA Team. I'm happy to share this post, in which I relate my experience about Basics of Business Finance.

INTRODUCTION:

This chapter provides an overview of the various sources from where funds can be procured for starting as also for running a business. It is important for any person who wants to start a business to know about the different sources from where money can be raised. It is also important to know the relative merits and demerits of different sources so that choice of an appropriate source can be made.

Meaning, Nature and Significance of Business Finance

Business is concerned with the production and distribution of goods and services for the satisfaction of needs of society. For carrying out various activities, business requires money. Finance, therefore, is called the life blood of any business. The requirements of funds by business to carry out its various activities is called business finance. A business cannot function unless adequate funds are made available to it. The initial capital contributed by the entrepreneur is not always sufficient to take care of all financial requirements of the business. The need for funds arises from the stage when an entrepreneur makes a decision to start a business. Similarly, some funds are required for day-to-day operations, say to purchase raw materials, pay salaries to employees, etc. Also when the business expands, it needs funds. The financial needs of a business can be categorized as follows:

(a) Fixed capital requirements:
In order to start business, funds are required to purchase fixed assets like land and building, plant and machinery, and furniture and fixtures. This is known as fixed capital requirements of the enterprise. The funds required in fixed assets remain invested in the business for a long period of time. A Trading concern is like For example, it may require small amount of fixed capital as compared to a manufacturing concern. Likewise, the need for fixed capital investment would be greater for a large enterprise, as compared to that of a small enterprise.

(b) Working capital requirements: The financial requirements of an enterprise do not end with the procurement of fixed assets. For example, if we would require more working capital as compared to a concern selling its goods and services on cash basis or having a speedier turnover. Similarly, larger funds may be required for building higher inventories for the festive season or to meet current debts or expand the business or to shift to a new location.

Classification of Sources of Funds :
In case of proprietary and partnership concerns, the funds may be raised either from personal sources or borrowings from banks, friends etc. In case of company form of organization, the different sources of business finance which are available may be categorized as:

Period Basis:
On the basis of period, the different sources of funds can be categorized into three parts. These are long-term sources, medium-term sources and short-term sources. 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. Where the funds are required for a period of more than one year but less than five years, medium-term sources of finance are used. These sources include borrowings from commercial banks, public deposits, lease financing and loans from financial institutions. Short-term funds are those which are required for a period not exceeding one year. Trade credit, loans from commercial banks and commercial papers are some of the examples of the sources that provide funds for short duration. 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. Wholesalers and manufacturers with a major portion of their assets tied up in inventories or receivables also require large amount of funds for a short period.

Ownership Basis:
On the basis of ownership, the sources can be classified into ‘owner’s funds’ and ‘borrowed funds'. Owner’s funds means funds that are provided by the owners of an enterprise, which may be a sole trader or partners or shareholders of a company. Apart from capital, it also includes profits reinvested in the business. The owner’s capital remains invested in the business for a longer duration and is not required to be refunded during the life period of the business. Such capital forms the basis on which owners acquire their right of control of management. Issue of equity shares and retained earnings are the two important sources from where owner’s funds can be obtained. ‘Borrowed funds’ on the other hand, refer to the funds raised through loans or borrowings. The sources for raising borrowed funds include loans from commercial banks, loans from financial institutions, issue of debentures, public deposits and trade credit. Such sources provide funds for a specified period, on certain terms and conditions and have to be repaid after the expiry of that period. A fixed rate of interest is paid by the borrowers as such funds.

Source of Generation Basis:
Another basis of categorizing the sources of funds can be whether the funds are generated from within the organization or from external sources. Internal sources of funds are those that are generated from within the business. A business, For example, we can generate funds internally by accelerating collection of receivables, disposing of surplus inventories and ploughing back its profit. The internal sources of funds can fulfill only limited needs of the business. External sources of funds include those sources that lie outside an organization, such as suppliers, lenders, and investors. When large amount of money is required to be raised, it is generally done through the use of external sources. External funds may be costly as compared to those raised through internal sources. In some cases, business is required to mortgage its assets as security while obtaining funds from external sources. Issue of debentures, borrowing from commercial banks and financial institutions and accepting public deposits are some of the examples of external sources of funds commonly used by business organizations.

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 organization depends on many factors like net profits, dividend policy and age of the organization.

Merits:
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 organization;
(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.

Limitations:
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 recognized by many firms. This may lead to sub-optimal use of the funds.

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 organizations as a source of short term financing. It is granted to those customers who have 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. A firm may also offer different credit terms to different customers.

Merits
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 organization.

Limitations:
Trade credit as a source of funds has certain limitations, which are given as follows:
(i)Availability of easy and flexible trade credit facilities may induce a firm to indulge in overtrading, which may add to the risks of the firm;
(ii)Only limited amount of funds can be generated through trade credit;
(iii)It is generally a costly source of funds as compared to most other sources of raising money.

Factoring:
Factoring is a financial service under which the ‘factor’ renders various services which includes:
(a) Discounting of bills (with or without recourse) 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. The factor becomes responsible for all credit control and debt collection from the buyer and provides protection against any bad debt losses to the firm. There are two methods of factoring- recourse and non-recourse. Under recourse factoring, the client is not protected against the risk of bad debts. On the other hand, the factor assumes the entire credit risk under non resource factoring i.e., full amount of invoice is paid to the client in the event of the debt becoming bad.

(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 record. Factors may also offer relevant consultancy services in the areas of finance, marketing, etc. The factor charges fees for the services rendered. Factoring appeared on the Indian financial scene only in the early nineties as a result of RBI initiatives. The organizations that provides such services like SBI Factors and Commercial Services Ltd., Canara bank Factors Ltd., Foremost Factors Ltd., State Bank of India, Canara Bank, Punjab National Bank, Allahabad Bank. In addition, many non-banking finance companies and other agencies provide factoring service.