Notes - Business Finance

6. Business Finance

6.1 Concept of Business Finance     

Business is concerned with the production and distribution of goods and services for the satisfaction of needs of society. In order to produce and distribute goods and services, business needs money.

Therefore, finance is called the soul of any business. The requirement of funds by business to carry out its various activities is called business finance.

6.1.1 Significance of Business Finance

Adequate finance is required in the business because of following reasons

• Meeting expenses concerning establishment of business.
• Finance is required for purchasing fixed assets.
• Prompt payment of debts builds credit worthiness of the business, so funds can be easily borrowed.
• Sufficient funds enable the business to avail of the business opportunities.
• Smooth functioning of business.
• Meeting day-to-day exercises of the business.
• Bridging the gap between production and sales. Availability of funds is necessary to carry on production activities continuously.
• Availability of adequate finance at proper time in the hands of competent management ensures the success of the business.

6.1.2 Financial Needs of Business

The financial needs of the business can be categorised into the following

• To start up business lots of fund is required to purchase fixed assets such as land, plant, machinery etc. The investment which is made to purchase these assets are known as fixed capital requirements of the enterprise.

• The procurement of fixed asset is not the only task of the business to conduct daily operations, a huge amount of capital is required. It is known as the working capital requirements of the business.

6.2 Sources of Raising Funds

The sources through which funds can he raised are Business Finance

6.2.1 Owner’s Fund

• Funds provided by the owners of an enterprise which may be a sole trader or partners or shareholders of a company are termed as owner’s fund. Apart from capital they can also include profit reinvested in the business.
• The capital of a company is divided into small units called shares. Each share forms a unit of ownership and is offered for sale so as to raise capital for the company.

1. Equity Shares

The capital obtained by issue of equity shares is known as share capital. It is considered as the permanent source of capital for a company. As it is not required to be returned during the life of the company. The return on equity shares is paid in the form of dividend. The company pays dividend only in case of profits. The rate of dividend is not fixed and depends upon the surplus profit left after paying dividend to preference shareholders. Because of these features, the equity shareholders are known as the ‘residual owners’ of the business. They are original risk bearers. Voting rights are conferred upon them, to enable them to participate in the affairs of the business.

• Generally, dividend to equity shareholders is paid out of profits, but in certain conditions it can be paid out of reserves also.

2. Preference Share

The capital raised by issue of reference shares is called preference share capital. Preference shares confer following two preferential rights to its holders

(i)   Preferential right to receive dividend at a pre-determined rate, before dividend is paid to equity shareholders.

(ii)   Preferential right to receive repayment of capital at the time of dissolution of the company. This right authorises them to receive payment against capital before any .amount is paid to equity shareholders.

Preference shares resemble debentures as they bear fixed rate of return. Also, as dividend is payable only at the discretion of the directors and only out of profit after tax to that extent, they resemble equity shares.

3. Retained Profits

It means that part of trading profits which are not distributed in the form of dividends, but retained by directors for future expansion of-the company. These can be also stated as ploughing back of profits. In other words, they are sacrifice made by equity shareholders therefore, they also referred to as internal equity. It is calculated as

\[\left( RE \right)=Net\text{ }Income-Dividends\]

6.2.2 Borrowed Fund

These are the funds which are not provided by owners but by other parties. There are various sources of funds in this category such as debentures bonds, public deposit, loan from banks and financial institutions etc.

1. Debenture and Bonds Debenture:

It is an important instrument for raising long-term debt capital. Debenture is basically a written acknowledgement of the company, under its seal, that it has borrowed certain amount of money. In general, it refers to long-term loan to the company by the debenture holders on which they receive a fixed rate of interest.

Bonds are also loan instruments and resemble debentures in all aspects except one. No pre-determined rate of interest is announced at the time of issuing bonds, but a specific rate of interest is announced while issuing debentures.

2. Loan from Financial Institution

The government has established a number of financial institutions all over the country to provide finance to business organisations. These institutions are established by the Central as well as State Governments.

These institutions provide loan for medium and long-term needs of a business. These institutions also provide technical assistance and managerial services to business units. These institutions provide for specialised finance, keeping in view, the diverse requirements of business units.

Since these institutions facilitate industrial development in the country, they are called development banks.

3. Loans from Commercial Banks

Commercial banks such as State Bank of India (SBI), Canara Bank, etc, advance money to the business firms for different purposes and different time periods. Banks extend credit in many ways, like, cash credits, overdrafts, discounting of bills of exchange and issue of letter of credit.

The repayment is made by the borrower in instalments as per the agreement between the bank and the borrower. Interest charged by banks depends upon a number of factors, such as nature of advance, period for which the loan is taken, etc. Loan is generally offered by banks on the basis of security of assets. The loan can be repaid either in instalments or in lump-sum.

4. Public Deposit

It refers to the deposits that are raised by business organisations directly from the public. Under it; a company raises loans from the public for a fixed period of time at a fixed rate of interest.

This rate is generally higher than that offered on bank deposits. Companies generally invite public deposits for a period upto three years. Its acceptance is regulated by the Reserve Bank of India. Any person who is interested in depositing money with a company can do so by filling a prescribed form. The company issues a deposit receipt as acknowledgement of debt.

6.3 Trade Credit Deposit

Trade credit is an important external source of working capital financing. It is a short-term credit extended by suppliers of goods and services in the normal course of business, to a buyer in order to enhance sales.

Trade credit arises when a supplier of goods or services allows customers to pay for goods and services at a later date. Cash is not immediately paid and deferral of payment represents a source of finance.

6.4 Microcredit

• The word microcredit did not exist before the 70s. Now it has become a buzz-word among the development practitioners.
• In the process, the word has been imputed to mean everything to everybody.
• No one now gets shocked if somebody uses the term microcredit to mean agricultural credit, or rural credit, or cooperative credit, or consumer credit, credit from the savings and loan associations, or from credit unions, or from money lenders.
• Microcredit is part of microcredit, which provides a wider range of financial services, especially savings accounts, to the poor.
• Microcredit is the extension of very small loans (microloans) to impoverished borrowers who typically lack collateral, steady employment and a verifiable credit history.

6.5 International Financing Instruments

Apart from equity shares, preference shares and retained earnings there are various avenues present by which a company can raise funds internationally. Say if an Indian company wants to obtain capital from abroad, can it do it? The answer is yes and to facilitate the transaction there are certain instruments, which are discussed below.

6.5.1 American Depository Receipt (ADR)          

As, already discussed a company can raise owned funds by issuing equity shares in the domestic market. But, if the company wants to raise finance from the American capital market, then it can issue equity shares specially targeted for the American investors by issuing American Depository Receipts (ADRs). These receipts are basically shares of an Indian company denominated in US dollars.

The stock of many non-US companies trades on US stock exchanges through the use of ADRs. Dividend on ADRs is also paid in US dollars and may be traded like shares of US-domiciled companies. However, ADRs do not carry voting rights.

6.5.2 Global Depository Receipt (GDR)

Global Depository Receipts (GDRs) are similar to American Depository Receipts, except that they are issued in some other foreign country, except for America.

In the Indian context, a GDR is an, instrument issued abroad by an Indian company to raise funds in some foreign currency and is listed and traded on a foreign stock exchange. A holder of GDR can convert anytime the number of shares it represents.

6.6 Credit Rating Agencies

Credit rating is an assessment of the probability of default on payment of interest and principal on a debt instrument. It is not a recommendation to buy, sell or hold a debt instrument. Rating only provides an additional input to the investor and the investor is required to make his own independent and objective analysis before arriving at an investment decision. The Indian credit rating industry has evolved over a period of time. Indian credit rating Industry mainly comprises of CRISIL, ICRA, CARE, ONICRA etc.

These can be explain in detail as follow.

6.6.1 CRISIL

Credit Rating and Information Services of India Limited (CRISIL) was promoted is 1988 jointly by ICICI and UTI.

It offers various services such as

• Rating services for debentures, fixed deposit programmes, preference shares, short-term instruments such as commercial paper, certificates of deposits and structured obligations.
• Credit assessment service.
• Rating information services on product targeted towards decision-makers in the corporate sector and individual investors.
• Advisory services consultancy to various organisations in public/ private sectors and State Governments.
• The CRISIL view provides facts and opinion on the credit quality of a company.
• CRISIL BAN card service to provide analysed information on select public/ private sector banks, providing information on the background and management of the bank, its financial and productivity ratios, funding and lending profile etc.

6.6.2 ICRA

Investment Information and Credit Rating Agency of India Limited (ICRA) was promoted in 1991 by the Industrial Finance Corporation of India Limited, LIC, SBI and selected banks, institutions and financial services companies. The objective of ICRA is to provide guidance to investors or creditors in determining the credit risk associated with a debt instrument/ obligation. The ratings are based upon independent professional assessment of debt and other instruments, though they are not recommendation for buying, selling, holding of securities.

• ICRA rating is a symbolic indicator of the current opinion of the relative capabilities of timely servicing of debts and obligations.
• ICRA rates, long, medium and short-term debts including debentures, bonds, preference shares, fixed deposits and commercial papers.
• ICRA provides the following reports and assessments for the various companies.

6.6.3 CARE

• Credit Analysis and Research Limited (CARE) is a credit rating and information service company promoted by the Industrial Development Bank of India jointly with other financial institutions, Nationalised Banks and private sector finance companies.
• CARE commenced operations in 1993. CARE rates all types of debt instruments. A rating committee comprising professionals decide each rating. Other activities/services include industry studies, information services and credit reports on request.

6.6.4 ONICRA

• ONICRA stands for Onida Individual Credit Rating Agency of India and is a private company set-up by Onida Finance. It has been set-up to rate the credit-worthiness of non-corporate consumers. This rating can be used in the following areas: credit cards, leasing/hire purchase transactions, housing finance, rental agreements and bank finance.
• This company will provide a rating analysis of the individual to the ‘user’ for each potential transaction. The ‘user’ will thus, be able to measure the credit risk and consequently reduce the default rate.