FINANCIAL MANAGEMENT MODULE - 2

SOURCES OF FINANCE

[Link] are the various sources available to an indian businessman for raising
fund.(15 mark)(Repeated)

CLASSIFICATION OF SOURCES OF FINANCE

A.​Based on the period
Sources of finance can be classified into 3 categories based on the period.
I.​ Long term sources
Long term finance refers to the funds which are to be invested in the business for a
long period, say for a period over 5 years. Such finance is used for investment in
fixed assets like land, building, plant, machinery, furniture [Link] is known as
fixed capital requirements of an organization. Long term finance is required for
financing capital expenditure.

Long term sources of finance include,equity shares,preference shares,long term

loans,fixed deposit,ploughing back of profit.

II.​ Medium term sources

Where the funds are required for a period of more than one year but less than five
years, it is known as medium term finance. The need for medium term finance may
be for increasing the production capacity, introduction of a new product,
modernization of plant and machinery, making an advertisement campaign etc.

Medium term finance can be raised through debentures,medium term loans,public

deposits etc.
III.​ Short term sources
Short term finance is raised for a period of less than one year. It is required to meet
the day to day needs of the business. It is known as the working capital of an
organization. It is the amount required for investment in current assets like stock of
raw materials, debtors,and also funds required for current expenses such as wages,
salaries, rent etc.
Main sources of short term finance are bank credit,customer advances,trade
credit,factoring,money market instruments such as commercial papers,Certificate
of deposit etc.
B.​ Based on ownership
I.​ Owned capital
Owned capital refers to the amounts contributed by the owners into the business. In
a sole proprietorship, the proprietor brings the owned funds from his personal
property. In a partnership, the capital contributed by the partners is called owned
funds. Funds raised by the issue of shares, retained earnings,profit and surplus etc
are the owned funds in a joint stock company. It will
remain in the business over a long period and is not expected to be withdrawn
otherwise than on the winding up of the business.
II.​ Borrowed capital
Borrowed funds refer to funds raised from external borrowings. The sources of
borrowed funds include issue of debentures, public deposits,bonds and loans from
financial institutions and banks. Periodical payments of interest and repayment of
loan amount on expiry date are required even if there is no profit.

C.​ Based on the source of finance

I.​ Internal sources
The sources of funds which are generated by the business itself are known as
internal sources of [Link] back of profits,retained
earnings,profits,surpluses and depreciation funny etc are the main internal sources
of business finance.
II.​ External sources
External sources of funds are those that are generated from outside the business.
For example, loans from commercial banks and financial institutions, issue of
debentures, public deposits, lease financing, trade credit, factoring etc.
Requirements of large amounts of funds can be fulfilled by these sources. The
funds raised through these sources are costly as compared to the funds raised
through internal sources.

D.​Based on mode of financing

I.​ Security financing
It includes ownership securities and creditorship [Link] securities
include equity shares,preference shares,deferred shares,no par stock and sweat
equity [Link] securities include debentures and bonds.

II.​ Internal financing

Through retained earnings or ploughing back of profit,capitalisation of profit and
depreciation.

III.​ Loan financing

Through raising of long term and short term loans.

I.​ SECURITY FINANCING

If the finance is mobilised through the issue of securities such as shares and
debentures it is called security [Link] known as corporate securities.

A.​OWNERSHIP SECURITIES(CAPITAL STOCK)

The ownership securities, also called capital stock, are commonly called as shares.
Shares are the most universal method of raising finance for the business concern.
It consist of following securities:
I.​ Equity shares
★​According to the Indian Companies Act,1956,the equity shares are those
which are not preference shares.
★​Equity shares were earlier known as ordinary shares. The holders of these
shares are the real owners of the company. They have a voting right in the
meetings of shareholders of the company. They have control over the
working of the company.
★​The rate of dividend on these shares depends upon the profits of the
company. They may be paid a higher rate of dividend or they may not get
anything.
★​These shareholders take more risk as compared to preference shareholders.
★​Equity capital is paid after meeting all other claims including that of
preference shareholders. They take risk both regarding dividend and return
of capital.
★​ Equity share capital normally cannot be redeemed during the lifetime of the
company.
Features:
➢​No fixed rate of dividend: The rate of dividend on equity capital depends
upon the availability of surplus funds. There is no fixed rate of dividend on
equity capital.
➢​Right to vote: Equity shareholders have voting rights and elect the
management of the company.
➢​Payment after debt repayment:In the case of winding up of the company,an
equity shareholder will be paid back his capital only after all other
debts,including the preference share capital have been fully paid.
➢​Risk bearers: Equity shareholders are entitled to receive what is left after all
prior claims have been paid.

Advantages of equity shares:To the company

➢​Source of long term and fixed capital:It is the best source of long term
finance. A company has no obligation to repay its equity share capital except
at the time of winding up of the company subject to availability of funds.
➢​No fixed burden:There is no obligation to pay a fixed rate of dividend on
theses shares
➢​No charge on assets:Funds can be raised through equity share issue without
creating any charge on the asset of the company .So companies assets can be
used for raising additional loans.
➢​Credit worthiness:Equity capital provides credit worthiness to the
[Link] share capital acts as a cushion to creditors.
➢​Right shares:By issuing right shares,it is possible to raise more funds.
➢​Dividend policy:A company may follow an elastic dividend policy creating
huge reserves for its development programmes.

Advantages of equity shares:To the investors

➢​High return:If the company is successful and the level of profit is high,
equity shareholders enjoy very high returns.
 ➢​Right to participate in control and management:Equity shareholders enjoy
full voting rights in the management of the company.
➢​Attraction for persons having limited income:As the prices of equity shares
are very low,persons of limited income can purchase these shares.
➢​Pre-emptive right:The issue of new equity shares to the existing shareholders
of a company in proportion to their prevailing shareholdings is called the
right issue. The special privilege of the existing shareholders to get priority
on such allotment is called "pre-emptive right". It enables the existing
shareholders to buy additional equity before allotment to the fresh
applicants.

Disadvantages of equity shares:To the company

➢​Trading on equity is not possible:If only equity shares are issued,then the
company cannot take advantage of trading on equity.
➢​Over capitalisation:Excessive issue of equity shares may lead to
[Link] results in low earning capacity by the presence of
idle capital.
➢​Dilutes the control:An additional issue of equity shares dilutes the control of
existing shareholders.
➢​Not flexible:Equity share capital is a permanent source of finance. It can’t be
refunded during the lifetime of the company.
➢​Speculation:Issue of equity shares leads to unhealthy speculation on account
of fluctuations in the market value of shares.

Disadvantages of equity shares:To the investors

➢​Not suitable to cautious investors:Investors who desire to invest in safe
securities with a fixed income have no attraction for equity shares.
➢​Capital loss during depression:During economic downturns or
depressions,the value of equity shares can significantly decline,resulting in
capital losses for investors.
➢​Loss on liquidation:If the company becomes insolvent,equity shareholders
lose heavily because they are the owners of the company and they are paid
in the end.
➢​Irregular and uncertain income:Equity shares do not offer a fixed rate of
return,and dividend payments can be irregular and uncertain.
 II.​ Preference share
Shares which carry preferential rights in receiving a fixed rate of dividend and
repayment of capital on winding up of the company are called preference shares.
Preference shareholders have voting rights only on matters affecting them.
Types of preference shares
1)​ Cumulative and non-cumulative

Cumulative preference shares enjoy the right to accumulate unpaid dividends in

the future years.
Non- cumulative preference shareholders will not get their arrear dividend, but
only current year's dividend.

2)​ Participating and Non participating

Participating shareholders have a right to get share of the surplus profits in

addition to the fixed rate of dividend
Non-participating shareholders have no right to get the share of surplus profits,
but will get only a dividend at a fixed rate.

3)​ Redeemable and Irredeemable

Preference shares which will be repaid after the expiry of a specified period are
called redeemable preference shares.
Preference shares which will be repaid only on winding up of the company are
called irredeemable preference shares.

4)​ Convertible and Non convertible

Preference shares that can be converted into equity shares within a specified period
of time are known as convertible preference shares.
Preference shares that cannot be converted into equity shares are known as
non-convertible preference shares.

Advantages of preference shares:To the company

➢​Fixed return:The dividend payable on preference share is usually fixed.
 ➢​Flexibility:They can be redeemed, if necessary. Issue of redeemable
preferences shares help a company to replay the capital when it is no longer
required in the business.
➢​No charge on assets:Preferences shares do not create any charge on the asset
of the company.
➢​No voting right:Preference shareholders have no voting rights.
➢​Low rate of cost of capital:The cost of capital of preference share is
comparatively less than the cost of equity share.

Advantages of preference shares:To the investors

➢​Regular and fixed income:The investors get a fixed rate of dividend on
preference shares.
➢​Preferential rights:In case of winding up of the company,preference shares
carry preferential rights as regards to the payment of dividend and
repayment of capital.
➢​Fair security:Preference shares enjoy minimum risk.
➢​Voting right for safety of interest:Preference shares although carry no voting
rights,the preference shareholders can vote on matters directly affecting their
rights.
➢​Less risky:Preference shares are helpful for those investors who do not take
any risk and those who want to get a regular rate of return.

Disadvantages of preference shares:To the company

➢​Costly source of finance:The rate of dividend on preference shares is
generally higher than the rate of interest on debentures.
➢​Financial burden:It is a burden on a company's profit as most of them were
cumulative preference shares.
➢​Adverse effect on credit worthiness:Frequent delay or non payment of
dividend adversely affects the credit worthiness of the firm.
➢​Erosion of cash:Compulsory redemption of preference share on maturity will
lead to outflow of cash.

Disadvantages of preference shares:To the investors

➢​No voting right:Preference shareholders enjoy no voting rights except under
specific conditions.
 ➢​Fixed income:The dividend on preference shares is fixed,even if the
company earns huge profit,except participating preference shares.
➢​Redemption:The company redeems the redeemable preference shares at any
time,when it feels convenient.
➢​No claim over the surplus:They have no claim over the surplus profits and
assets of the company.
➢​No guarantee of assets:The interests of preference shareholders are not
protected by the assets of the company.

III.​ Deferred shares

Also called as founder [Link] these shares are normally issued to founders
for their service rendered to the [Link] on Companies Act,no public
company can issue deferred [Link] the company earns huge profit,then the
shareholders are entitled to receive higher dividends than the preference and equity
shareholders.
IV.​ No par stock
Those shares which have no face value are called No Par [Link] company
issues No Par shares which are divided into a number of specific shares without
any specific [Link] Par value stock prices are determined by the amount
that investors are willing to pay for the No Par shares in an open market.
V.​ Sweat equity
It is the non monetary investment that owners or employees contribute to a
business [Link] and entrepreneurs often use this form of capital to fund
their businesses by compensating their employees with stock rather than
cash,which also helps to align risks and rewards.

B.​ CREDITORSHIP SECURITIES(DEBT CAPITAL)

[Link] are the various sources of debt financing?(Repeated)

It represents debentures and bonds.A debenture or bond is an acknowledgement of
debt.
I.​ Bonds
A bond is an instrument acknowledging the debt whereby one person binds himself
to another for payment of specified sum of money on a specified date. Basically
there is no significant difference between bond and debenture. The only difference
is that debentures are instruments issued by the corporate sector, whereas bonds are
issued by the government, semi-government bodies and public corporations.
Usually bonds bear a comparatively lower rate of interest than debentures. The
following are the important types of Bonds issued by corporates:

5. Bunny bonds:A bond that offers investors the option to reinvest coupon
payments into additional bonds with the same coupon and maturity.

II.​ Debentures

[Link] is a debenture?Explain the merits of raising funds through debentures(5

mark)

A debenture is an acknowledgement that the company has borrowed a certain sum

of money ,which it promises to repay at a future date. Debenture holders are the
creditors of the company. They get a fixed rate of interest at specified intervals
say 6 months or one year.

Features:
1. A debenture is a certificate of an acknowledgement of debt of a company.
2. Debenture represents borrowed capital.
3. Interest on debenture is payable at a fixed rate.
 4. Debenture holders are creditors of the company
5. Debenture holders have no voting rights.
6. It can be written as an expense on the debit side of the profit and loss account.
7. Debenture may involve a charge on the assets of the company.

TYPES OF DEBENTURES
I.​ Simple,Naked or Unsecured Debentures
Debentures which don’t create a charge on the assets of the company are called
unsecured debentures
II.​ Secured or mortgaged debentures
Debentures which create a charge on the assets of the company are called secured
debentures.
III.​ Bearer debentures
Bearer debentures are those which are issued without the names of debenture
holders. These can be transferred by mere delivery.
IV.​ Registered debentures
Registered debentures are those which are duly recorded in the Register of
Debenture holders maintained by the company.
V.​ Redeemable debentures
Debentures issued with a condition that they will be redeemed or repaid after a
specified period are called redeemable debentures. It provides flexibility to the
capital structure.
VI.​ Irredeemable debentures
These debentures are repayable only at the time of winding up of the company.
They are also known as perpetual debentures.
VII.​ Convertible debentures
The holders of these debentures have an option to convert their holdings into
equity shares after a specified period
VIII.​ Non convertible debentures
These debentures cannot be converted into shares in future. The holders of such
debenture remain creditors of the company.
IX.​ Guaranteed debentures
These are debentures on which payment of interest and principal are guaranteed by
third parties,generally banks.
 X.​ Collateral debentures
These are debentures that a company issues to financial institutions as additional
security for a loan.

Advantages of debentures:To the company

➢​Debentures provide a long term source of funds to a company.
➢​Interest payable on debentures is lower than the rate of dividend payable on
shares
➢​Financing through them is less costly as compared to the cost of preference
or equity capital as the interest payment on debentures is tax deductible.
➢​As a debenture does not carry voting rights,financing through them does not
dilute control of equity shareholders on management.
➢​Over capitalisation can be controlled by redeeming the redeemable
debentures.
➢​Debenture enables the company to trade on equity and thereby increases the
earnings per share.

Advantages of debentures:To the investors

➢​Debentures provide a fixed and regular source of income to the investors.
➢​Debentures are for those who want a safe and secure income as they are
guaranteed payments with high interest rates.
➢​They have priority over other unsecured creditors when it comes to debt
repayment.
➢​Many investors prefer debenture as an investment because most of them are
redeemable after a definite period.

Disadvantages of debentures:To the company

➢​Payment of interest on debenture is mandatory and when a company is
making low profit,non payment of interest can even lead to bankruptcy for
the firm.
➢​If the interest on debenture is not paid by the company,Then debenture
holders can file a petition for winding up of the company.
 ➢​Debenture puts a permanent burden on the earnings of a
[Link],there is a greater risk when the earnings of the company
fluctuate.
➢​Each company has certain borrowing [Link] the issue of
debentures,the capacity of a company to further borrow funds reduces.

Disadvantages of debentures:To the investors

➢​Debenture holders are not allowed to participate in company meetings and
do not have voting rights. Thus they do not have any say in the company
matters or policies.
➢​Debenture holders will only receive the fixed rate of interest and they do not
have any claim on surplus profits.
➢​Interest on debenture is fully taxable,meaning the investor must pay income
tax on the entire amount received.
II. INTERNAL FINANCING - RETAINED EARNINGS(PLOUGHING BACK
OF PROFITS)
★​Out of total profits earned by a company in a particular year, a certain
percentage is retained in the business without distributing as dividend among
shareholders, this undistributed profit is known as retained profit.
★​It is a source of internal financing or self financing. It is also known as
‘ploughing back of profit’.
★​ It is treated as an ownership fund and will serve the purpose of long term
and medium term financing.
★​It is a usual practice of a company to transfer a part of its profit to the
general reserve every year. When these reserves are accumulated into a large
amount, after a few years, this can be employed in modernization, expansion
etc. of the business.
★​It can be used as a main source of funds without creating any charge against
the assets of the company.

Advantages:To the company

➢​It is a cost effective method of financing
➢​Ensures stable dividend policy
➢​Retained profits increases the financial strength and earning capacity of the
business.
➢​As an internal source, it is more dependable than external sources.
➢​Improves the credit worthiness of the company

Advantages:To the investors

➢​The dividend rate will not be reduced and thus their investment is safe.
➢​Stable dividend policy enhance market value of shares
➢​The increased value of shares enables the shareholders to borrow money
from banks against the security of such shares.

III. LOAN FINANCING

A firm may meet its financial requirements by taking both short term and long term
loans. Short term finance is required to meet the short-term needs of working
capital. It is used for the purchase of raw material, office equipment and payment
for short-term obligations. Long term finance is required for investment in plant
and machinery, land and buildings, and other fixed assets.

a)Sources of short term finance

1.​ 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 goods without
immediate payment. The volume and period of trade credit depends on factors such
as reputation of the purchasing firm, financial position of the seller, volume of
purchase, competition in the market etc.

2.​ Bank credit

Commercial banks extend short-term finance to business concerns by way of
granting short-term loans, cash credit, overdraft, and discounting of bills. This
source of fund is essential for their working capital requirements and meeting
short-term obligations

3.​ Public deposits

The companies may raise short-term finance by accepting public deposits from
employees, customers, shareholders of the company and from the general public at
a rate of interest which is higher than that offered by commercial banksCompanies
generally invite public deposits for a period up to three years. It is a source of
medium term or short term finance. Public deposits are unsecured loans and the
depositors are like ordinary creditors.

4.​ Retained earnings - (already discussed)

5.​ Factoring
It is a transaction in which a business sells its invoices or accounts receivables to a
third party financial company known as factor, for immediate fund. The factor then
collects payment on those invoices from the customers of such a business
establishment. It is an immediate source of short-term finance
 6.​ Commercial paper
It is an important source of short term finance having a maturity period of 7 days to
one year. Commercial paper is an unsecured promissory note issued by a firm to
other business firms, insurance companies, banks etc. Being an unsecured debt,
Commercial paper can be issued only by the firm having a good credit [Link] is
sold at a discount from its face value and redeemed at its face value.
7.​ Inter-corporate deposits
IV. NEW INNOVATIVE SOURCES OF FINANCE
1)​ Venture capital
Venture capital financing is a process whereby funds are pooled in for a period of
around 10 years and investing it in venture capital undertakings for a period of 3 to
5 years with an expectation of high returns.
➔​Basically it is an equity finance.
➔​ It is a long term investment in growth oriented industries.
➔​ It focusses on new companies or start-up companies.
➔​It is given for implementing new ideas, the risk inherent is very high.
➔​ It creates employment opportunities.
2)​ Bridge finance
A bridge loan is a type of short-term loan, typically taken out for a period of 2
weeks to 3 years pending the arrangement of larger or longer-term financing. It is
usually called a "bridging loan" in the United Kingdom, also known as "Caveat
loan" or "Swing loan".

3)​ Lease financing

A lease is an arrangement in which the owner of the asset, called lessor, grants to a
firm or person, called lessee, the use of the property for a specified period for an
agreed sum of rent. It is a contract between lessor and lessee for a fixed period for
the use of a specific asset.
Two types of leasing:

​Financial lease
It is a long term arrangement which is irrevocable during its primary lease
[Link] known as capital [Link] is a lease that transfers substantially all the
risks and rewards incidental to ownership of an asset to the lessee.

​Operating lease
An operating lease is defined as being any lease other than a finance [Link] a
lease agreement gives the lessee the right to use the leased property for a limited
period of time. It does not give the lessee all the benefits and risks that are
associated with the asset. The lessor is responsible for the maintenance of the asset,
insurance and all other expenditure. Operating lease is also termed as an "open-end
lease" since the lessee has the option to terminate the agreement by notice.
If the lessee bears the cost of insuring and maintaining the leased equipment, such
type of operating lease is called "Dry Lease".
If the lessor bears the cost of insuring and maintaining the leased equipment, such
type of operating lease is called "Wet Lease"

4)​ Hire purchase

5)​ Seed capital

Seed capital is the funding required to get a new business started. This initial
funding, which usually comes from the business owner, supports preliminary
activities such as market research, product research and development and business
plan development. Seed capital funding is considered high-risk because the
business is not fully functional and has no track record. Investors who provide seed
capital funding often do so for a stake in the company.

6)​ Factoring
 7)​ Forfaiting
Forfaiting is a means of financing used by exporters that enables them to receive
cash immediately by selling their medium term receivables (the amount due from
the importer) at a discount, and eliminates risk by making the sale without
recourse, which means the exporter has no liability regarding possible default.
(Commerce companion youtube channel)

8)​ Securitisation

9)​ Depository receipts

It is a negotiable financial instrument that allows investors of any country to trade
or invest in the shares of a company in any other country.
Indian Depository Receipts
It is a financial instrument denominated in Indian rupees which enables foreign
companies to raise funds from the Indian securities market by offering entitlement
to foreign equity.

PREVIOUS YEAR QUESTIONS

Q1. Mention any 2 drawbacks of debt financing(2 mark)

★​Obligation to Repay with Interest

Debt financing requires regular payments of both principal and interest, which can
put a strain on a business's cash flow, especially during periods of low revenue or
unexpected expenses.

★​Increased Financial Risk:

High levels of debt can increase a company's financial risk, as it may struggle to
meet its debt obligations, potentially leading to financial distress or even
bankruptcy if the business defaults.

★​Collateral Requirements:
Lenders often require collateral to secure the loan, and failure to repay may result
in the loss of assets.

★​Repayment Schedule:
Debt financing often involves a fixed repayment schedule, which can be
challenging for businesses with fluctuating cash flows.

★​Impact on Credit Rating:

Defaulting on debt obligations can negatively impact a business's credit rating,
making it more difficult to borrow money in the future.

Q2. What are the merits of raising funds from a commercial bank?(5 mark)
(Repeated)

★​Quick Access to Funds:

Commercial banks can provide rapid access to capital, which is crucial for
businesses needing immediate funding for operations, investments, or expansion.

★​Flexibility in Financing:
Banks offer diverse loan products and repayment schedules, allowing businesses to
tailor financing to their specific needs and cash flow.

★​Boosts Economic Growth:

By providing loans and lines of credit, commercial banks enable investments,
consumption, and expansion, ultimately contributing to economic growth.
 ★​Facilitates Trade:
Commercial banks play a crucial role in facilitating international trade by
providing payment processing and foreign exchange services.

★​Encourages Savings and Investment:

Banks offer various savings and investment products, encouraging the public to
save and invest, which in turn fuels economic activity.

★​Safe Deposit and Security:

Commercial banks provide secure facilities for depositing money, safeguarding it
against theft or loss.

★​Credit Creation:
Commercial banks play a role in the creation of credit, which leads to an increase
in production, employment, and consumer spending, thereby boosting the
economy.

★​Professional Management:
Commercial banks offer professional management and expertise in financial
matters, providing valuable guidance to businesses.

★​No Ownership Dilution:

Unlike equity financing, debt financing from banks does not involve giving up
ownership or control of the company.

★​Tax Benefits:
Interest paid on debt is tax-deductible in most situations, reducing the overall cost
of borrowing.

★​Enhances Operational Flexibility:

Borrowing from banks can enhance operational flexibility, allowing businesses to
respond quickly to market opportunities and customer needs.

Q3. What is recourse and non recourse factoring?(2 mark)

Recourse Factoring:
The business selling the invoices (the "seller") is responsible for any unpaid
invoices, even if the customer (the "debtor") defaults. If the customer doesn't pay,
the factoring company can demand the seller repurchase the invoice or cover the
loss. Recourse factoring is generally more common and typically offers lower
factoring fees because the risk is shared or borne by the seller.

Non-Recourse Factoring:
The factoring company (the "factor") assumes the risk of non-payment by the
customer. If the customer doesn't pay, the business is not liable to repurchase the
invoice or cover the loss. Non-recourse factoring typically comes with higher fees,
as the factor is bearing more risk.

Q4. What do you mean by debt financing?(2 mark)

Debt financing is a time-bound activity where the borrower needs to repay the loan
along with interest at the end of the agreed period. The payments could be made
monthly, half yearly, or towards the end of the loan [Link] debt financing,the
organisation retains complete control and [Link] debt interest is tax
[Link] organisations with good credit history and collaterals can only
make use of this.

Opting for debt financing enables businesses to enjoy tax deductions, maintain
ownership control, and lower the cost of capital. However, it can be tricky to obtain
debt as financial institutions and investors require collateral and a strong credit
history. Organizations must consider working with accounting and tax
professionals to fully understand how debts can impact their cash flow and whether
it suits them.

Q5. Commercial banks are important source of short term finance to an indian
[Link](5 mark)

Merits were already discussed.

Commercial banks are a crucial source of short-term finance for Indian businesses,
providing essential working capital finance, which is crucial for small and
medium-sized businesses to cover daily operating expenses and ensure liquidity by
various instruments like loans, overdrafts, and credit facilities.

Indian commercial banks offer a range of short-term financing instruments,

including:
Loans: These are typically repaid within a year or less and can be used for various
purposes, such as purchasing inventory or equipment.
Overdrafts: These allow businesses to draw funds from their bank account beyond
their deposited balance, up to a pre-agreed limit.
Credit Facilities: These include credit cards and lines of credit, which provide
businesses with access to funds for short-term needs.
Cash Credits: These are a form of loan where the borrower can draw funds up to a
certain limit and repay them as required.
Discounting of Bills: Banks purchase or discount commercial bills of exchange,
providing businesses with immediate access to funds.

Working capital finance from commercial banks is particularly important for Small
scale and medium scale businesses as it helps them manage cash flow, purchase
raw materials, and meet payroll obligations.

By providing access to short-term financing, commercial banks enable businesses

to invest in growth opportunities, expand operations, and modernize their
infrastructure.
Q6. Explain the merits and demerits of raising long term fund from specialised
financial institutions(5 mark)

In order to improve the financial status of a country,the state owns some financial
[Link] state-owned financial institutes are referred to as specialised
financial [Link] banks for agriculture and agricultural cooperatives are
examples.

Sources of long term finance include equity shares,preference shares,long term

loans(It provides businesses with a lump sum of funds for an extended period to
finance large scale projects.),retained earnings and fixed deposits(It is a type of
savings account where individuals or businesses deposits funds for a fixed
period,earning interest and can be used as a long term source of finance when the
deposit matures.)

Functions

Granting loans-To grant loans for a longer period to industrial establishments.

Establishment of business units-To help the establishment of business units that
require large amounts of funds and have a long gestation period.
Economic development-To provide support for the speedy development of the
economy in general and backward regions in particular.
Advisory services-To offer specialized services operating in the areas of
promotion, project assistance, technical assistance services and training and
development of entrepreneurs.
Help in new projects-To provide technical and professional management services
and help in identification, evaluation and execution of new projects.

Merits

Long term finance:Financial institutions provide long term finance, which are not
provided by commercial banks.
Advisory services:Besides providing funds, many of these institutions provide
financial, managerial and technical advice and consultancy to business firms.

Increases goodwill:Obtaining a loan from financial institutions increases the

goodwill of the borrowing company in the capital market which helps in raising
funds easily from other sources.
Easy repayment:As repayment of loan can be made in easy instalments, it does not
prove to be much of a burden on the business.
Reliable source:The funds are made available even during periods of depression,
when other sources of finance are not available.

Demerits
Rigid procedure-Financial institutions follow rigid criteria for granting [Link]
many formalities make the procedure time consuming.
Restrictive conditions-Financial institutions put certain restrictions such as
dividend payment etc.
Interference-Financial institutions have government officials as board of directors
which restricts the power of the company.
Limited availability-These institutions focus on specific industries,sectors,which
means their funding may not be accessible for all types of businesses.

Q7. What are the advantages of using retained earnings as a source of long term
fund?(5 mark)

No Interest or Dividend Payments: Retained earnings do not require interest or

dividend payments, reducing the financial burden on the company.
No Debt or Equity Creation: Using retained earnings does not create new debt or
equity, maintaining the company's existing capital structure.
Flexibility: Retained earnings can be used for various purposes, such as financing
new projects, expanding operations, or repaying debt.
No Risk of Default: Since retained earnings are internally generated funds, there is
no risk of default or non-repayment.
Tax Benefits: Retained earnings are not subject to taxes until they are distributed as
dividends, providing tax benefits to the company.
Increased Shareholder Value: Reinvesting retained earnings can lead to increased
profitability and shareholder value over time.

Reduced Dependence on External Funding: Using retained earnings reduces the

company's dependence on external funding sources, such as loans or investors.

Q8. How is trade credit used by a business organisation as a source of short term
financing?(5 mark)

Trade credit is a common source of short-term financing for businesses.

Trade credit is a type of financing where a supplier allows a business to purchase
goods or services without immediate payment.
Delayed Payment Terms: Suppliers offer delayed payment terms, such as 30, 60, or
90 days, allowing the business to pay for goods or services after they have been
sold or used.
Interest-Free Financing: Trade credit is often interest-free, making it a
cost-effective source of short-term financing.

Increased Cash Flow: By delaying payment, businesses can maintain cash flow and
use funds for other purposes, such as investing in new opportunities or paying off
debts.
Reduced Need for Working Capital: Trade credit can reduce the need for working
capital, as businesses can rely on suppliers to provide goods or services without
immediate payment.
Flexibility: Trade credit can be negotiated with suppliers, allowing businesses to
tailor payment terms to their specific needs.

By using trade credit effectively, businesses can manage cash flow, reduce costs,
and maintain relationships with suppliers.

[Link] any 2 methods by which commercial banks advance short term credit.(2
mark)

Overdraft Facility: Commercial banks provide an overdraft facility to their

customers, allowing them to withdraw more funds than they have in their account.
This facility is usually provided for a short period, and the customer is required to
repay the overdraft amount along with interest.

Cash Credit: Commercial banks provide cash credit to their customers, which is a
short-term loan facility. The customer is allowed to borrow a certain amount of
money, and the loan is usually secured by collateral such as inventory, stocks, or
other assets. The customer is required to repay the loan along with interest within a
specified period.