- State the meaning, nature and importance of business finance
- Classify the various sources of business finance
- Evaluate merits and limitations of various sources of finance
- Identify the international sources of finance
- Examine the factors that affect the choice of an appropriate source of finance
Sources of Business Finance
Study Action Plan (Sorted by Difficulty)
Learning Objectives
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Revision Notes & Summary
TopChapter 8: Sources of Business Finance
Learning Objectives
- State the meaning, nature, and importance of business finance.
- Classify the various sources of business finance.
- Evaluate merits and limitations of various sources of finance.
- Identify the international sources of finance.
- Examine the factors that affect the choice of an appropriate source of finance.
Meaning and Significance of Business Finance
- Business finance refers to the funds required to establish and run business operations.
- Essential for purchasing fixed assets, daily operations, and growth plans.
Classification of Sources of Funds
1. Time Period
- Long-term sources: Exceeding 5 years (e.g., shares, debentures).
- Medium-term sources: More than 1 year but not exceeding 5 years (e.g., bank loans).
- Short-term sources: Not exceeding 1 year (e.g., trade credit).
2. Ownership
- Owner's funds: Provided by owners (e.g., equity shares, retained earnings).
- Borrowed funds: Raised through loans (e.g., debentures, bank loans).
3. Source of Generation
- Internal sources: Generated within the business (e.g., retained earnings).
- External sources: Outside the business (e.g., loans from banks).
Merits and Limitations of Debentures
Merits
- Preferred by investors seeking fixed income with lower risk.
- Fixed charge funds that do not participate in profits.
- Suitable when sales and earnings are stable.
- Interest payments are tax-deductible.
Limitations
- Permanent burden on earnings, increasing risk during fluctuations.
- Repayment provisions during financial difficulties.
- Reduces borrowing capacity for further loans.
Factors Affecting the Choice of Source of Funds
- Cost: Consider procurement and utilization costs.
- Financial Strength: Ability to repay principal and interest.
- Form of Organization: Legal status influences available sources.
- Purpose and Time Period: Match source with the intended use and duration.
Examples of Sources of Finance
- Trade Credit: Credit extended for purchasing goods without immediate payment.
- Lease Financing: Renting an asset for a specified period with periodic payments.
- Commercial Banks: Provide loans for various purposes and time periods.
Conclusion
Understanding the various sources of business finance is crucial for making informed decisions regarding funding options for business operations and growth.
Practice Test – MCQs, True/False
TopMultiple Choice Questions
A.
It is an unsecured money market instrument.
B.
It can be issued for maturities up to one year.
C.
It is a secured instrument requiring collateral.
D.
It provides a continuous source of funds.
Correct Answer: C
Solution:
Commercial Paper is an unsecured money market instrument, which does not require any collateral. It is issued for maturities up to one year and provides a continuous source of funds.
Chapter Concept:
Public Deposits and Commercial Paper
A.
It is secured by collateral.
B.
It is an unsecured money market instrument.
C.
It is issued for a period exceeding one year.
D.
It is only available to new and moderately rated firms.
Correct Answer: B
Solution:
Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note.
Chapter Concept:
Public Deposits and Commercial Paper
A.
Providing short-term trade credits to manage day-to-day operations.
B.
Offering long-term loans for acquiring fixed assets like machinery and equipment.
C.
Issuing commercial papers for quick liquidity.
D.
Facilitating the sale of company's equity shares in the stock market.
Correct Answer: B
Solution:
Financial institutions play a crucial role in providing long-term loans that are essential for acquiring fixed assets such as machinery and equipment, which are necessary for industrial expansion.
Chapter Concept:
Role of Financial Institutions
A.
Trade credit
B.
Equity shares
C.
Commercial paper
D.
Public deposits
Correct Answer: B
Solution:
Equity shares are a long-term source of finance suitable for funding requirements exceeding 5 years, making them appropriate for purchasing new machinery.
Chapter Concept:
Classification of Sources of Funds
A.
Trade credit involves borrowing funds from financial institutions, while factoring involves selling receivables to a third party.
B.
Trade credit is a long-term financing option, whereas factoring is used for immediate cash flow needs.
C.
Trade credit requires collateral, whereas factoring does not involve any security on assets.
D.
Trade credit is a costlier source of finance compared to factoring.
Correct Answer: A
Solution:
Trade credit is a short-term financing option where a supplier allows a buyer to purchase goods or services on account, deferring payment to a later date. Factoring, on the other hand, involves selling a company's receivables to a third party (factor) at a discount for immediate cash. Thus, option A correctly distinguishes between the two.
Chapter Concept:
Trade Credit and Factoring
A.
Preference shares dilute the control of existing shareholders.
B.
Preference shares carry a higher rate of dividend compared to debentures.
C.
Preference shareholders have voting rights.
D.
Preference shares create a charge on the assets of the company.
Correct Answer: B
Solution:
The rate of dividend on preference shares is generally higher than the rate of interest on debentures, making it a more expensive source of finance.
Chapter Concept:
Sources of Business Finance
A.
Equity shares
B.
Debentures
C.
Trade credit
D.
Retained earnings
Correct Answer: C
Solution:
Trade credit is a short-term source of funds commonly used by businesses to finance day-to-day operations.
Chapter Concept:
Classification of Sources of Funds
A.
Equity capital
B.
Loan capital
C.
Retained earnings
D.
Preference share capital
Correct Answer: B
Solution:
Debentures represent loan capital as they are a form of borrowing where the company promises to pay a fixed rate of interest and repay the principal at a future date.
Chapter Concept:
Issue of Shares and Debentures
A.
It requires a high credit rating.
B.
It is a reliable source of finance.
C.
New companies may find it difficult to raise funds through public deposits.
D.
It involves high flotation costs.
Correct Answer: C
Solution:
New companies generally find it difficult to raise funds through public deposits, making it an unreliable source for them.
Chapter Concept:
Public Deposits and Commercial Paper
A.
High initial investment cost
B.
Restrictions on asset modifications
C.
Dilution of ownership control
D.
Requirement of collateral
Correct Answer: B
Solution:
Lease arrangements may impose restrictions on the lessee, such as prohibiting alterations or modifications to the leased asset, thereby affecting operational flexibility.
Chapter Concept:
Lease Financing
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Sources of Business Finance
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Locked • AI Weakness TrackerTrue or False
Correct Answer: True
Solution:
Trade credit is indeed a short-term financing method where one trader extends credit to another for purchasing goods and services, facilitating purchases without immediate payment.
Chapter Concept :
Trade Credit and Factoring
Correct Answer: False
Solution:
GDRs are used to raise funds in international markets, but they do not provide voting rights to their holders. They only provide dividends and capital appreciation.
Chapter Concept :
International Sources of Finance
Correct Answer: True
Solution:
In non-recourse factoring, the factor assumes the entire credit risk and provides protection against bad debt losses.
Chapter Concept :
Trade Credit and Factoring
Correct Answer: False
Solution:
The cost of finance, including both the cost of procurement and the cost of utilizing the funds, is a significant factor affecting the choice of a source of funds.
Chapter Concept :
Factors Affecting Choice of Finance
Correct Answer: False
Solution:
In lease financing, the lessee does not become the owner of the asset at the end of the lease period. The asset returns to the lessor.
Chapter Concept :
Lease Financing
Correct Answer: True
Solution:
Lease financing is a contractual agreement where the lessee uses an asset owned by the lessor in return for periodic payments, without taking ownership of the asset.
Chapter Concept :
Lease Financing
Correct Answer: True
Solution:
Retained earnings are a permanent source of funds as they are generated internally and do not require repayment.
Chapter Concept :
Retained Earnings
Correct Answer: True
Solution:
Factoring is a financial service that accelerates cash flow by discounting receivables, providing a flexible and predictable cash inflow pattern.
Chapter Concept :
Sources of Business Finance
Correct Answer: False
Solution:
Owner's funds do not provide a fixed rate of return. Unlike borrowed funds, which require regular interest payments, owner's funds, such as equity shares, offer returns based on the company's profitability and do not guarantee fixed returns.
Chapter Concept :
Owner's Funds vs Borrowed Funds
Correct Answer: False
Solution:
The working capital requirements vary not only with the size of the business but also with factors such as the nature of the business, sales turnover, and credit policies.
Chapter Concept :
Fixed and Working Capital Requirements
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