Classification of Business Finance

Source of Business Finance

Classification of Business Finance

Business finance is classified into three types with reference to time period i.e. Long term finance (more than 5 years), Medium term finance (above 1 year but below 5 years) and Short term finance (within one year) for carrying on business operations. Long term finance can be mobilized by issue of shares and debentures, term loans from commercial banks and financial institutions, and retained earnings. Medium term finance can be mobilized by public deposits, leasing, medium term loans from banks

and financial institutions. Short term fiancé can be raised through public deposits, trade credit, customer advance, , hypothecation, cash credit, bank overdraft, pledge, mortgage etc.

The various sources of business finance can be classified into three categories on the basis of i) period basis ii) ownership basis iii) source of generation basis

On the basis of period

The different sources of finance can be further grouped into three categories on the basis of period

1) Short term finance 2) Medium term finance 3) Long term finance

Source of Short Term Finance

Short term funds are those sources which are required by the business firms for a period of within one year. Some of the important sources of short term finance are briefly explained below.

1. Loans and Advances

Loan is a direct advance made in lump sum which is credited to a separate loan account in the name of borrower. The borrower can withdraw the entire amount in cash immediately. It can be repaid in one or more installments. But the interest on loans and advances is calculated on the whole of the amount borrowed right from the date of sanction. It may be secured or unsecured. Loans and advances are usually sanctioned by pledge of specific assets like Fixed Deposit Receipts, Document of Title to the Goods, Shares, Debentures, etc.

2. Bank Overdraft

Bank overdraft refers to an arrangement whereby the bank allows the customers to overdraw the required amount from its current deposit account within a specified limit. Interest is charged only on the amount actually overdrawn.

3. Discounting Bills of Exchange

When goods are sold on credit, the suppliers generally draw bills of exchange upon customers who are required to accept it.

The duration of such bills of exchange may be ranging from 15 days to 180 days. Instead of holding the bills till the date of maturity, borrowers generally prefer to get them discounted with the bank. Discounting bills of exchange refers to an act of selling a bill to obtain payment for it before its maturity.

4. Trade Credit

Trade credit is  the  credit  extended  by  one trader to another for the purpose of purchasing goods and services. Purchaser need not pay money immediately after the purchase. Such credit appears in balance sheet as Trade Creditors, or Accounts Payable. Trade credit is very simple and convenient method of raising short term finance. There is no formality involved in availing this facility. There is no need to give any security for trade credit. It is said to be more economical than bank loans.

5. Pledge

A customer transfers  the  possession  of  an article with the creditor (banker) and receives loan. Till the repayment of loan, the article is under the custody of the borrower. If the debtor fails to refund the loan, creditor (banker) will auction the article pawned and adjust the outstanding loan from the sale proceeds.

6. Hypothecation

This is loan taken by depositing document of title to the property with the banker. Of course the physical possession of asset property is with the borrower.  If the  borrower fails to repay the loan amount, the article hypothecated will be sold in auction by the banker concerned. Business people hypothecate goods or equipment to get this type of loan. It is a  loan taken on the security of movable asset.

7. Mortgage

This is a type of loan taken from the bank by lodging with the banker title deeds of immovable assets like land and building. Business people raise loans by depositing the title deeds of the properties with the bank.

8. Loans Against the Securities

Banks accept various types of securities like fixed deposit receipt, book debts, insurance policies, supply bills, shares debentures, bonds of company, document of title to the goods like railway receipt, bill of lading, trust receipt, warehouse keeper’s receipt, book debt, and so on, and provides loan on the basis of the aforesaid securities.

9. Clean Loan

Banks provide clean loan to certain customer of outstanding credit worthiness on the basis of their character, capacity and capability. It simply grants loan without any physical security. In other words clean loan is loan given without any security or with personal security.

10. Commercial Paper (CP)

Commercial paper (CP) is an unsecured money market instrument in the form of    a promissory note. Corporates, Primary Dealers (PD), and All India Financial Institutions are eligible to issue Commercial Paper. It was introduced in India in 1990 under Section 45W of the Reserve Bank   of India Act. It is issued by a firm to raise funds for a short period. It can be issued for maturities between a minimum of 7 days and a maximum of up to one year from the date of issue.

11. Hire Purchase Finance

Small scale firms can acquire industrial machinery, office equipments, vehicles etc., without making full payment through hire purchase. With the help of assets acquired through hire purchase, they can produce and sell. From the earnings, payments can easily be made in installments. Ultimately the ownership of assets can be acquired. Now several agencies like National Small Industries Corporation (NSIC) provide machinery and equipments to small scale units on hire purchase basis.

12. Factoring

Factoring is one of the methods of raising business finance through sale or mortgage of book debts. Under this method, business concerns sell the  accounts  receivable  to  a finance company called a factor at a discount.

Source of Medium Term Finance

1. Loans from Banks

When the bank lends for a period ranging from more than one year to less than five years, it is called medium term loan. All aspects of bank finance have been discussed under the head long term sources of finance.

2. Loan from Financial Institutions

Where the financial institutions lends for a period ranging from more than one year to less than five years, it is called medium term loan. All aspects of institutional finance have been discussed under the head long term sources of finance.

3. Lease Financing

Lease financing denotes procurement of assets through lease. For many small and medium enterprises, acquisition of plant and equipment and other permanent assets will be difficult in the initial stages.  In such a situation Leasing is helping them to a greater extent. Leasing here refers to the owning of an asset by any individual or a corporate body which will be given for use to another needy business enterprise on a rental basis.

The firm which owns the asset is called ‘Lessor’ and the business enterprise which hires the asset is called ‘Lessee’. The contract is called ‘Lease’. The lessee pays a fixed rent on agreed basis to the lessor for the use of the asset. The terms and conditions like lease period, rent fixed, mode of payment and allocation of maintenance, are mentioned in the lease contract. At the end of the lease period, the asset goes back to the lessor. Alternatively lessee can own the asset taken on lease by  payimg the balance of price   of asset concerned to lessor. Hence lease finance is a popular method of medium term business finance.

Source of Long Term Finance

Long term sources of funds refer to those sources which are required by the business firms for a period exceeding five years. The various sources of long term business finance are briefly explained below.

1. Shares

Corporate enterprises generally obtain capital mainly from share  capital  which  is divided into small units called shares. Each share has a nominal value. The  Indian Companies Act 2013 describes a share “to be a share in the share capital of  a company”. The person holding a share is called shareholder who has the interest in the assets and profit of the company. There are two types of shares namely Equity shares and Preference shares.

i. Equity Shares

The fund raised by issuing equity shares is termed as equity share capital. Equity share is the most important source of raising long term capital by a company. These shares do not carry any special or preferential rights in the matter of payment of annual dividend and repayment of capital at the time of winding up . Equity shareholder enjoys more voting rights  in  proportion to number of shares held by them. Thus they take part in the management of the company.

ii. Preference Shares

The fund raised by issue of preference shares is called preference share capital. Preference shares are those shares which enjoy priority regarding payment of dividend at a fixed rate out of the net profits of the company. They will get their dividend every year before any dividend is paid to equity shareholders. They will have a right to get their settlement before the claims of equity shareholder are settled at the time of liquidation of company. However they do not have voting rights.

2. Debentures

Debentures are an important instrument for raisinglongtermdebtcapital. Acompanycan raisefundsthroughissueofdebentureswhich bear a fixed rate of interest. The individual or person subscribing to debentures is called debenture holder. An entity raising funds through debenture has to pay interest at the stipulated date whether it earns profit or loss. Failure to pay interest leads to liquidation of the company. Debenture holders do not have voting rights.

3. Retained earnings

Retained earnings refer to the process of retaining a part of net profit year  after  year and reinvesting them in the business. It is also termed as ploughing back of profit.      An individual would like to save a portion of his/her income for meeting the contingencies and growth needs. Similarly profit making company would retain a portion of the net profit in order to finance its growth and expansion in near future. It is described to be the most convenient and economical method of finance.

4. Public Deposits

Under this method, companies invite public deposits by giving advertisement in the media. It offers deposit schemes for a longer tenure. Person interested in making public deposit has to undergo a simple formality. The interest rates offered by companies on public deposits are relatively higher than the bank. Public deposits are perceived to be economical for the company since the interest rate on deposits is less than the cost of borrowing from the bank.

The company need not offer any of its assets as security on accepting public deposits. Moreover the control of the company is not diluted as the deposit holders do not enjoy the voting rights.

5. Long Term Loan from Commercial Banks

Commercial banks are important sources of raising business finance for various purposes as well as for different time periods. Banks in modern times offer long tenured loans for a period beyond 5 years also. The long term loan taken from banks can be repaid either in installment or in one lump sum. Banks provide long term loans on the security of assets of the business firms. Nowadays the formalities for taking long term loans are simplified by the Reserve Bank of India.

6. The Loans from Financial Institutions

Central and State Governments have established various financial  institutions  in India to provide finance to business enterprises for a longer period. These institutions aim at promoting the industrial development  of  a  country.  In  addition  to loan assistance, they conduct market surveys, provide technical assistant and supply managerial talents to borrowing enterprises to manage the companies. They mainly provide large funds for longer period for financing expansion,  reorganisation and modernisation of an enterprise. They allow longer repayment period to repay the loan. Hence the borrowing companies do not feel the stress of repayment. Financial institutions provide term loans mostly to highly rated corporates by the credit rating companies.

On the Basis of Ownership

Business finance can be divided into two categories based on ownership of funds.

1. Owner’s Funds

Owner’s funds mean funds which are provided by the owner of the enterprises who may be an individual, or partners or shareholders of a company. The profits reinvested in the business (ploughing back of profit or retained earnings) come under owner’s funds. These funds are not required to be refunded during the life time of business enterprise. It provides the owner the right to control the management of the enterprise.

2. Borrowed Funds

The term ‘borrowed funds’ denotes the funds raised through loans or borrowings. For example debentures, loans from banks and financial institutions, public deposits, trade credit, lease financing, commercial papers, factoring, etc. represent borrowed funds.

·           These borrowed sources of funds provide specific period before which the fund is to be returned.

·           Borrower is under legal obligation to pay interest at given rate at regular intervals to the lender.

·           Generally borrowed funds are obtained on the security of certain assets like bonds, land, building, stock, vehicles, machinery, documents of title to the goods, and the like.

On the Basis of Generation of Funds

The sources of funds can be grouped into two categories based on generation.

1. Internal Sources

This includes all those sources generated from within the business enterprises. For instance retained earnings, collection from receivables (trade debtors and bills receivable), surplus from disposal of old assets and so on. These sources can meet only limited needs of business enterprise.

2. External Sources

External sources of funds include all those sources which generate funds from outside the business enterprise. For example issue of shares and debentures, borrowings from banks and financial institutions, public deposits, factoring, leasing, hire purchase, etc.