Sources of Finance

Prerequisites

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1. Introduction

Every business needs funds for various purposes like purchasing assets, meeting day-to-day expenses, expansion plans, and research. The question is: Where does this money come from?

Sources of finance are the avenues from which a business raises the required funds.

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2. Classification of Sources

2.1 Based on Time Period

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Medium-term Sources (1-5 years): Lease Financing, Hire Purchase, Public Deposits

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2.2 Based on Ownership

1. Owner's Funds (Equity Capital):

• Equity Shares
• Retained Earnings
• Does NOT require repayment
• Owners have control and claim on profits

2. Borrowed Funds (Debt Capital):

• Debentures, Bonds, Loans
• MUST be repaid with interest
• No ownership control
• Fixed obligation regardless of profit

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3. Detailed Source Descriptions

3.1 Equity Shares

Definition: Represent ownership capital; shareholders are owners of the company.

Features:

• Permanent capital (no repayment)
• Voting rights in company decisions
• Dividend depends on profit (not fixed)
• Last to get paid in liquidation

Advantages:

• No fixed burden (dividend only if profit)
• No repayment required
• Improves creditworthiness

Disadvantages:

• Dilution of control
• Dividend expectations can be high
• Costlier in long run (dividends not tax-deductible)

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3.2 Preference Shares

Definition: Hybrid instrument giving preference in dividend payment and capital repayment over equity.

Features:

• Fixed dividend rate (e.g., 10% Preference Shares)
• Preferred over equity but after debt
• Usually no voting rights
• Can be cumulative or non-cumulative

Types:

1. Cumulative: Unpaid dividends accumulate
2. Non-Cumulative: Unpaid dividends lapse
3. Redeemable: Can be repaid after specified period
4. Irredeemable: Permanent capital

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3.3 Debentures / Bonds

Definition: Long-term debt instrument issued by company acknowledging a loan.

Features:

• Fixed interest rate (e.g., 12% Debentures)
• Interest paid even if no profit
• Creates charge on assets (secured)
• Repayment on maturity

Advantages:

• Interest is tax-deductible (reduces tax burden)
• No dilution of control
• Cheaper than equity

Disadvantages:

• Fixed obligation (even in loss)
• Reduces borrowing capacity
• Risk of bankruptcy if unable to pay

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3.4 Retained Earnings

Definition: Portion of profit kept back in the business instead of distributing as dividend.

Other Names: Ploughing back of profits, Internal financing

Advantages:

• No cost (no interest/dividend)
• No dilution of control
• No formalities required
• Signals financial strength

Disadvantages:

• Limited amount available
• Shareholders may be dis satisfied
• Over-reliance can signal lack of growth opportunities

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3.5 Term Loans

Definition: Loans from banks/financial institutions for medium to long term (3-10 years).

Features:

• Repayable in installments (EMIs)
• Interest charged
• Secured by mortgage of assets
• Covenants and conditions attached

Sources: Banks, IFCI, IDBI, SIDBI

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3.6 Trade Credit

Definition: Credit extended by suppliers allowing payment after delivery (e.g., credit period of 30 days).

Features:

• Most common short-term source
• No explicit interest (but cash discount forgone)
• Builds business relationships

Example: A retailer buys goods worth ₹1,00,000 on 30 days credit. He can sell goods and collect cash before paying the supplier.

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4. Comparison Table

Feature	Equity	Debt (Debentures)
Nature	Ownership	Borrowed funds
Return	Dividend (variable)	Interest (fixed)
Payment	Only if profit	Mandatory
Tax	Not deductible	Tax-deductible
Risk to Company	Low	High (fixed burden)
Control	Shareholders = Owners	No control to lenders
Cost	Higher (long-term)	Lower (tax benefit)

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Exam Pattern Questions and Answers

Question 1: "Distinguish between Equity Shares and Preference Shares." (6 Marks)

Answer:

Equity Shares (3 marks):

1. Dividend: Variable, depends on profit and board decision. Not fixed.
2. Voting Rights: Equity shareholders have voting rights and control the company.
3. Repayment: Permanent capital, never repaid during company's life.
4. Claim on Assets: Last to be paid in case of liquidation (residual claimants).

Preference Shares (3 marks):

1. Dividend: Fixed rate (e.g., 10%), paid before equity dividend.
2. Voting Rights: Generally no voting rights except in special circumstances.
3. Repayment: Can be redeemable (repaid after fixed period) or irredeemable.
4. Claim on Assets: Paid before equity but after debenture holders in liquidation.

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Question 2: "Why are debentures considered cheaper source of finance than equity shares?" (4 Marks)

Answer: Debentures are cheaper than equity for two main reasons:

1. Tax Shield (2 marks): Interest on debentures is a tax-deductible expense, which reduces the effective cost. If a company pays 12% interest and tax rate is 30%, the effective cost is only 12% × (1-0.30) = 8.4%. Dividends on equity are NOT tax-deductible, so the full cost remains.

2. Fixed vs Variable (2 marks): Debenture interest is fixed and known, while equity dividend expectations grow with company profit. Over time, dividends can exceed interest payments. Additionally, equity holders expect capital appreciation, further increasing the implicit cost of equity.

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Summary

Sources Classification:

• By Time: Short-term, Medium-term, Long-term
• By Ownership: Owner's Funds vs Borrowed Funds

Key Sources:

1. Equity - Ownership, no repayment, voting rights
2. Preference - Hybrid, fixed dividend
3. Debentures - Debt, tax-deductible interest
4. Retained Earnings - Internal, cost-free
5. Trade Credit - Short-term, from suppliers

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Quiz Time! 🎯

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