Exercise Solutions Available
Step-by-step answers for all textbook questions in this chapter
Chapter Overview
Sources of Business Finance is Chapter 8 of CBSE Class 11 Business Studies (Part 2). It covers all the ways a business can raise money — from owner's capital and retained earnings to borrowing through debentures and bank loans. Understanding the classification, merits, and limitations of each source is essential for answering exam questions on financing decisions.
Key Definitions
| Term | Definition |
|---|---|
| Business Finance | Money required for carrying out business activities — starting, running, and expanding a business. |
| Equity Shares | Shares that represent ownership in a company; holders get dividends and voting rights. |
| Preference Shares | Shares with a preferential right to dividend and repayment of capital before equity shares. |
| Debenture | A document acknowledging a debt — the company borrows at a fixed interest rate. |
| Retained Earnings | The portion of net profit kept in the business for future use instead of distributing as dividend. |
| Term Loan | A loan from a bank or financial institution repayable over a medium to long period (3–15 years). |
| Working Capital Loan | A short-term loan to finance day-to-day operations. |
| Trade Credit | Credit extended by suppliers — the buyer pays after a specified period (30/60/90 days). |
| Lease Financing | Using an asset by paying periodic rent instead of purchasing it outright. |
| Hire Purchase | An arrangement where the buyer takes possession but pays in installments; ownership transfers after the last payment. |
| Public Deposits | Deposits accepted by a company directly from the public for a fixed period at a fixed interest rate. |
| Factoring | Selling accounts receivable to a factor (financial institution) at a discount for immediate cash. |
Detailed Concepts
1. Classification of Sources of Finance
Sources of Finance
├── Based on Ownership
│ ├── Owned Funds (equity, preference, retained earnings)
│ └── Borrowed Funds (debentures, loans, public deposits)
├── Based on Source
│ ├── Internal (retained earnings, depreciation provisions)
│ └── External (shares, debentures, loans, trade credit)
├── Based on Period
│ ├── Long-term (equity, debentures, term loans)
│ ├── Medium-term (preference shares, term loans, lease)
│ └── Short-term (bank overdraft, trade credit, commercial paper)
└── Based on Generation
├── Domestic (Indian sources)
└── International (FDI, ADRs, GDRs)
2. Equity Shares
Features:
- Permanent capital — not refundable during the company's lifetime.
- Highest risk — last to receive dividend and repayment.
- Voting rights — equity shareholders elect the board.
- No fixed dividend — depends on profits.
- Residual claimants — paid after all others.
Merits:
- No obligation for fixed dividend.
- Permanent capital — no repayment pressure.
- No charge on assets — company can raise further loans.
- Increases creditworthiness.
Limitations:
- Costliest source — high dividend expectations.
- Dilution of control — new shareholders get voting rights.
- Risk of takeover — if one group acquires majority shares.
3. Preference Shares
Features:
- Preferential right to dividend (fixed rate).
- Preferential right to repayment during liquidation.
- Usually no voting rights (except when dividend is in arrears).
Types of Preference Shares:
| Type | Feature |
|---|---|
| Cumulative | Unpaid dividends accumulate and must be paid before equity dividend |
| Non-cumulative | Unpaid dividends do not accumulate; lost if not declared |
| Participating | After fixed dividend, may share in surplus profits |
| Non-participating | Only fixed dividend; no share in surplus |
| Convertible | Can be converted into equity shares after a period |
| Non-convertible | Cannot be converted into equity |
| Redeemable | Repaid after a fixed period |
| Irredeemable | Not repayable during the company's lifetime (now banned) |
Merits:
- Fixed dividend attracts investors.
- No voting rights — no dilution of control.
- Does not create charge on assets.
Limitations:
- Obligation to pay fixed dividend — even in loss years for cumulative type.
- Not a permanent source — redeemable preference shares must be repaid.
- Not popular with investors — lower return than equity.
4. Equity vs Preference Shares
| Basis | Equity Shares | Preference Shares |
|---|---|---|
| Dividend | Variable, paid after preference | Fixed, paid first |
| Voting Rights | Yes | Usually no |
| Risk | Highest | Moderate |
| Repayment | Last in liquidation | Before equity |
| Nature of Capital | Permanent | Redeemable |
| Control | Voting control | No voting control |
5. Debentures
Features:
- Acknowledgement of debt — debenture holders are creditors.
- Fixed interest — paid regardless of profit.
- No voting rights.
- Secured or unsecured.
- Redeemable — must be repaid on maturity.
Types of Debentures:
| Type | Feature |
|---|---|
| Secured (Mortgage) | Backed by assets of the company |
| Unsecured (Naked) | No asset backing |
| Convertible | Can be converted into equity shares |
| Non-convertible | Cannot be converted |
| Registered | Recorded in company's register; transfer by instrument |
| Bearer | Ownership by possession; transfer by delivery |
| Redeemable | Repaid after a fixed period |
| Irredeemable | No fixed maturity (now banned) |
| Zero Coupon | No interest; issued at deep discount, redeemed at face value |
Merits:
- Fixed interest — attractive to conservative investors.
- No dilution of control — no voting rights.
- Tax deductible — interest reduces taxable income.
- Cheaper than equity (lower cost due to lower risk).
Limitations:
- Obligation to pay interest even during losses.
- Creates charge on assets (secured debentures).
- Increases financial risk — debt-equity ratio rises.
- Repayment obligation on maturity.
6. Retained Earnings
Meaning: The portion of net profit not distributed as dividend, kept for business use.
Merits:
- No cost of raising — no issue expenses, no underwriting commission.
- No dilution of control.
- Positive signal — retained profit shows business health.
- Flexible — can be used as needed.
Limitations:
- Limited by profits — cannot raise beyond what is earned.
- Opportunity cost — shareholders forego dividend.
- May lead to mismanagement — easy money, no scrutiny.
- Dissatisfaction among shareholders expecting dividend.
7. Term Loans
Features:
- Provided by banks and financial institutions (SBI, IDBI, ICICI).
- Repayable over 3–15 years.
- Secured — backed by assets.
- Fixed or floating interest rate.
- Equated installments or bullet repayment.
Merits:
- Long-term funding for capital expenditure.
- Tax deductible interest.
- Retained ownership — no dilution of control.
- Flexible terms negotiable with the lender.
Limitations:
- Creates charge on assets.
- Obligation to repay regardless of profit.
- Restrictive covenants — lender may impose conditions.
- Difficult for new firms — need track record.
8. Short-Term Sources
| Source | Description | Key Feature |
|---|---|---|
| Bank Overdraft | Withdraw more than balance in current account | Interest on overdrawn amount; flexible |
| Cash Credit | Loan against pledge of inventory or receivables | Up to a sanctioned limit |
| Trade Credit | Credit from suppliers (30/60/90 days) | No interest if paid within period; spontaneous source |
| Public Deposits | Deposits from public for 1–3 years | Higher interest than bank FD; riskier |
| Commercial Paper | Unsecured promissory note by large companies | 15 days to 1 year; minimum Rs 5 lakh |
| Factoring | Selling receivables to a factor | Immediate cash; factor charges fee |
9. Lease Financing and Hire Purchase
| Basis | Lease Financing | Hire Purchase |
|---|---|---|
| Ownership | Remains with lessor | Transfers after last installment |
| Nature | Right to use asset | Installment buying |
| Depreciation | Lessor claims | Buyer claims |
| Return of Asset | Return at end of lease | Buyer keeps the asset |
| Example | Leasing a factory machine | Buying a car on installments |
10. Factors Affecting Choice of Finance
| Factor | Consideration |
|---|---|
| Cost | Interest on debt vs dividend expectation on equity |
| Risk | Debt increases financial risk; equity is risk-free for the firm |
| Control | Equity dilutes control; debt does not |
| Duration | Long-term need → equity/debentures; short-term → bank credit |
| Flexibility | Can the source be repaid early or adjusted? |
| Tax benefit | Interest on debt is tax deductible; dividend is not |
| Creditworthiness | Too much debt reduces future borrowing capacity |
| Form of organisation | Sole proprietorship cannot issue shares; only companies can |
Important Points for Exams
1. Equity shares carry the highest risk and highest return. 2. Preference shareholders get dividend before equity shareholders. 3. Debenture holders are creditors — they get interest, not dividend. 4. Interest on debentures is tax deductible; dividend is not. 5. Retained earnings have zero flotation cost. 6. Cumulative preference shares accumulate unpaid dividends. 7. Trade credit is a spontaneous source — it arises automatically from business operations. 8. Minimum subscription for a public issue is 90% of the offer.
Common Mistakes
1. Calling debenture holders "owners" — they are creditors, not owners. 2. Confusing cumulative and non-cumulative preference shares — cumulative accumulates unpaid dividends; non-cumulative does not. 3. Saying retained earnings have no cost — they have opportunity cost (shareholders forego dividend). 4. Confusing lease with hire purchase — in a lease, ownership stays with lessor; in hire purchase, ownership transfers after the last installment. 5. Forgetting that interest on debentures is tax deductible — this is a major advantage over equity. 6. Listing only long-term sources — exam questions may ask for short-term sources specifically.
Exam Tips
- For "classify sources of finance," draw the classification tree diagram.
- For "distinguish between" questions, use tables (equity vs preference, lease vs hire purchase).
- Always mention whether a source is owned or borrowed, and long-term or short-term.
- For case studies, identify the financing need (short/long term) and recommend the appropriate source with reasons.
- Know the types of preference shares and debentures — these are frequent 1-mark questions.
Detailed Case-Study Practice
Case 1: A new company wants to raise Rs 50 crore. Should it issue equity or debentures?
Analysis:
- If the company wants to avoid fixed interest obligation and dilution is acceptable — issue equity shares.
- If the company is profitable and wants tax-deductible interest — issue debentures.
- A balanced approach: mix of equity (say Rs 30 crore) and debentures (Rs 20 crore) for optimal cost-risk trade-off.
- Too much debt increases financial risk; too much equity is costly.
Case 2: A sole proprietor wants to expand his shop but cannot get a bank loan. What can he do?
Analysis:
- Use retained earnings if the business is profitable.
- Approach family and friends for capital.
- Take a small loan under MUDRA scheme.
- Apply for a bank overdraft against his current account.
- Consider trade credit from suppliers for purchasing stock.
Case 3: A company issues cumulative preference shares but fails to pay dividend for two years. What happens?
Analysis:
- The unpaid dividends accumulate and must be paid before any equity dividend is declared.
- Preference shareholders gain voting rights when their dividend is in arrears for two or more years.
- The company must clear the accumulated dividend before resuming equity dividends.
- This highlights the obligation that cumulative preference shares carry.
Key Terms Glossary
| Term | Meaning |
|---|---|
| Flotation cost | Cost of issuing securities — underwriting commission, brokerage, advertising |
| Debt-equity ratio | Proportion of debt to equity in a company's capital structure |
| Collateral | Asset pledged as security for a loan |
| Coupon rate | The fixed interest rate on a debenture or bond |
| Face value | The nominal value of a share or debenture as stated on the certificate |
| Market value | The price at which a share or debenture trades in the market |
| **Dividend | Distribution of profit to shareholders |
| Interest | Fixed payment to debenture holders or lenders |
Exam-Focused Practice Questions
1. Classify the sources of business finance. (5 marks) 2. Distinguish between equity shares and preference shares. (5 marks) 3. What are debentures? Explain their types, merits, and limitations. (6 marks) 4. Explain retained earnings as a source of finance. (4 marks) 5. Discuss the factors affecting the choice of a source of finance. (6 marks)
Quick Revision Notes
- Owned funds: Equity (permanent, voting, highest risk), Preference (fixed dividend, no voting), Retained earnings (zero cost, internal).
- Borrowed funds: Debentures (fixed interest, tax deductible, creditors), Term loans (3–15 years, secured), Public deposits (1–3 years, riskier).
- Short-term: Bank overdraft, cash credit, trade credit, commercial paper, factoring.
- Equity vs Preference: Variable vs fixed dividend; voting vs no voting; permanent vs redeemable; highest vs moderate risk.
- Debenture types: Secured/unsecured, convertible/non-convertible, registered/bearer, redeemable/irredeemable.
- Lease vs Hire purchase: Lease = use only; Hire purchase = ownership after last installment.
- Choice factors: Cost, risk, control, duration, flexibility, tax benefit, creditworthiness, form of organisation.
- Key fact: Interest on debt = tax deductible. Dividend on equity = not tax deductible.
Further Reading
- [Chapter 7 Guide — Formation of a Company](/school/cbse/class/11/business-studies/cbse-formation-of-a-company)
- [Chapter 9 Guide — Small Business and Entrepreneurship](/school/cbse/class/11/business-studies/cbse-small-business-entrepreneurship)
- [Class 11 Business Studies Subject Guide](/school/cbse/class/11/business-studies)
Frequently Asked Questions
They are classified as: owned funds (equity shares, retained earnings, preference shares), borrowed funds (debentures, bank loans, public deposits), and lease financing / hire purchase. Sources also differ as internal vs external, and long-term vs short-term.