Sources of Finance | ICSE Class 10 Commercial Studies Notes

This note covers the sources of finance in Commercial Studies: the meaning and functions of the capital market, the long-term sources of raising capital (equity shares, preference shares and debentures, with their types and the differences between shares and debentures), and the short-term sources from commercial banks (cash credit, overdraft and discounting of bills), with comparison tables and exam-style answers.

What is the capital market and what does it do?

The capital market is the part of the financial system where long-term funds are raised and lent.

It brings together those who have savings to invest for a long period and those who need money for a long period, such as companies setting up or expanding a business and governments funding development.

The capital market deals in long-term securities. Its main instruments are shares and debentures, which companies issue to raise capital, and government securities. The funds raised are used to buy fixed assets such as plant, machinery and buildings, so the money stays invested for years rather than weeks.

Definition: The capital market is the market for long-term funds, where savings are mobilised and made available to industry and government through the issue and trading of securities such as shares and debentures.

The capital market has two parts. The primary market is where a company issues new securities to investors for the first time and receives the money.

The secondary market is the stock exchange, where investors buy and sell securities already issued among themselves; the company does not receive this money, but the market gives investors the ability to sell, which makes them willing to buy in the first place.

Functions of the capital market

1. Mobilising savings: it collects scattered savings from households and institutions and channels them into productive investment.
2. Providing long-term funds: it supplies companies and governments with capital for fixed assets and long-term projects.
3. Facilitating the issue of securities: it provides the mechanism, through the primary market, for companies to issue shares and debentures to the public.
4. Providing liquidity: the secondary market lets investors sell their securities before maturity, so their money is not locked up for ever.
5. Determining prices: the buying and selling of securities on the stock exchange sets their market prices.
6. Spreading risk: by offering many securities, it lets investors hold a variety of investments and share risk with the company's owners.

These functions together make the capital market a link between savers and users of long-term funds. A company that needs to build a new factory can raise money by issuing shares or debentures, while a household with savings can earn a return by buying those securities.

The market also helps the economy to grow. When savings move out of idle holdings and into plant, machinery and buildings, more goods and services can be produced and more workers can be employed. A well-developed capital market therefore supports both the company that raises money and the saver who earns a return on it.

What are the long-term sources of raising capital?

Long-term sources provide funds that a company needs for many years and does not have to repay in the near future. The two main long-term sources are shares and debentures. Shares represent ownership of the company, while debentures represent a loan taken by the company.

Shares are of two main types: equity shares and preference shares. A company may issue both, and each type carries different rights and different claims on the company's profits. Debentures are also of several types, such as secured and unsecured, and convertible and non-convertible.

Both sources are raised through the capital market, which brings together savers with long-term funds and companies that need capital for fixed assets such as plant, machinery and buildings. A company that wants to expand can issue shares to the public or borrow through debentures, and in either case the money stays with the company for years rather than months.

Definition: Shares are units of ownership in a company that carry a share in its profits and a claim on its assets, while debentures are written acknowledgements of a loan to the company that carry a fixed rate of interest.

The choice between the two matters because it decides who bears the risk of the business. A shareholder gains when profits rise and loses when they fall, while a debenture holder receives the same fixed interest in a good year and a bad one. The next sections take each source in turn.

What are shares and what are their types?

A share is a unit of the capital of a company. The person who holds a share is a shareholder, that is, a part-owner of the company. The capital raised by issuing shares is called share capital.

Shareholders receive a return called a dividend, which depends on the profits of the company.

Shares are of two main types: preference shares and equity shares.

Preference shares

Preference shares are shares that carry two preferences over equity shares. First, the holders receive a fixed rate of dividend before any dividend is paid to equity shareholders.

Second, when the company is wound up, they are repaid their capital before equity shareholders. The dividend on preference shares is fixed, so it does not rise when profits rise.

Equity shares

Equity shares are the ordinary shares of a company. Their holders are the real owners of the company. The dividend on equity shares is not fixed; it depends on the profits and on the decision of the directors.

Equity shareholders have voting rights and take part in the management of the company through the general meeting. They bear the greatest risk, because they are paid last, but they also gain most when the company prospers.

Definition: Equity shares are ordinary shares that carry ownership, voting rights and a dividend that varies with profits, and whose holders are paid last on winding up.

What are debentures?

A debenture is a written acknowledgement of a loan taken by a company. The person who holds it is a debenture holder, who is a creditor of the company, not an owner.

The company pays a fixed rate of interest on debentures whether or not it earns a profit, and repays the principal after a stated period.

Because the interest is a charge against profits, it is paid before any dividend is declared. This makes debentures a cheaper source than shares in many cases, but it also means the company must find the interest even in a year when it makes a loss.

Definition: A debenture is a written acknowledgement of a loan to a company, carrying a fixed rate of interest and repaid after a stated period, whose holder is a creditor of the company.

Debenture holders have no voting rights, so issuing debentures raises money without bringing in new owners. That is why a company that does not want to share control often prefers this source.

What are the differences between shares and debentures?

Shares and debentures are both long-term sources of capital, but they differ in ownership, return, risk and repayment. The table below sets out the main differences.

The key point is that a shareholder is a part-owner who shares in profit and loss, while a debenture holder is a lender who receives a fixed return.

A company that does not want to share control may prefer debentures; a company that does not want a fixed burden of interest may prefer shares.

What are the short-term sources of finance from commercial banks?

Short-term sources provide funds for a few months, usually to meet working capital needs such as buying raw materials, paying wages and holding stock. The main short-term source is a loan from a commercial bank.

Commercial banks provide short-term finance in three common forms: cash credit, overdraft and discounting of bills.

Cash credit

Cash credit is a facility under which a bank allows a borrower to withdraw money up to a sanctioned limit against the security of stock or other assets.

The borrower pays interest only on the amount actually used, not on the whole limit. It is usually given for a year and renewed thereafter.

Overdraft

An overdraft is a facility allowed on a current account under which the account holder may withdraw more than the balance in the account, up to a sanctioned limit. Interest is charged on the amount overdrawn. It is usually given to traders and businesses for short periods.

Discounting of bills

Discounting of bills means selling a bill of exchange to a bank before its due date. The bank pays the holder the amount of the bill less a discount, and collects the full amount from the acceptor on the due date. The discount is the bank's charge for the service.

Definition: Discounting of bills is the sale of a bill of exchange to a bank before its due date, the bank paying the holder the amount of the bill less a discount and collecting the full amount on maturity.

Going beyond the syllabus

These ideas extend the unit and are not needed for the questions on it. The unit asks the meaning of each source; the capital structure and the worked calculations below show how the sources are used.

A company usually combines several sources rather than relying on one. It may raise long-term funds through equity shares and debentures and meet day-to-day needs through bank facilities.

The mix of sources is called the capital structure, and a company chooses it by weighing the cost of each source against the risk it brings.

Equity capital is costly but carries no fixed burden; debt is cheaper but must be serviced even in a bad year. A business that expects steady profits may lean on debentures, while one in an uncertain trade may prefer to raise more through shares.

The choice also depends on how much control the existing owners are willing to give up. Every new equity share carries a vote, so a company that issues a large number of equity shares may find that its original owners no longer hold the majority. Debentures avoid this problem, because their holders are creditors and cannot vote at general meetings.

Timing matters as well. A company that borrows heavily just before a slump may struggle to pay interest when profits fall, while one that has raised most of its money through shares can reduce or skip the dividend in a bad year without breaking any promise to a lender. A sensible mix therefore keeps the fixed burden of interest within what the company can pay even in a poor year, and uses shares for the rest.

Worked examples

Worked example 1. A company issues 10,000 equity shares of ₹10 each at par. It also issues 5,000 preference shares of ₹100 each at par, carrying a dividend of 8 per cent.

In its first year the company earns a profit of ₹6,00,000. What dividend is paid on the preference shares, and what is left for the equity shareholders?

Answer: Preference dividend = 8 per cent of (5,000 × ₹100) = 8 per cent of ₹5,00,000 = ₹40,000. Profit left for equity shareholders = ₹6,00,000 − ₹40,000 = ₹5,60,000. The equity dividend per share = ₹5,60,000 ÷ 10,000 = ₹56 per share, if the directors declare the whole amount.

Worked example 2. A company needs ₹50,00,000 for a new plant. It can raise the money either by issuing 5,00,000 equity shares of ₹10 each or by issuing 50,000 debentures of ₹100 each carrying 10 per cent interest.

In the first year the company expects a profit before interest and tax of ₹8,00,000. Which source should it choose if it wishes to avoid a fixed burden?

Answer: With debentures, interest = 10 per cent of ₹50,00,000 = ₹5,00,000, leaving ₹3,00,000 for shareholders. With equity shares, there is no interest, so the whole ₹8,00,000 is available for shareholders.

The company should choose equity shares if it wishes to avoid a fixed burden of interest, but it must accept that control will be shared with the new shareholders.

Worked example 3. A trader has a cash credit limit of ₹2,00,000 from a bank at 12 per cent per annum. During the year he uses ₹1,50,000 for 6 months and ₹50,000 for the other 6 months. What interest does he pay?

Answer: Interest for the first 6 months = 12 per cent of ₹1,50,000 × 6/12 = ₹9,000. Interest for the next 6 months = 12 per cent of ₹50,000 × 6/12 = ₹3,000.

Total interest = ₹9,000 + ₹3,000 = ₹12,000. He pays interest only on the amount actually used, not on the full limit of ₹2,00,000.

Worked example 4. A trader holds a bill of exchange for ₹40,000 due after 3 months. The bank discounts it at 12 per cent per annum. How much does the trader receive, and what does the bank collect on maturity?

Answer: Discount = 12 per cent of ₹40,000 × 3/12 = ₹1,200. Amount received by the trader = ₹40,000 − ₹1,200 = ₹38,800. The bank collects the full ₹40,000 from the acceptor on the due date, so its earning is the discount of ₹1,200.

Kinds of preference shares

Preference shares are of several kinds:

• Cumulative preference shares: if the company cannot pay the dividend in a year, the unpaid dividend accumulates and must be paid before equity shareholders get anything in later years.
• Non-cumulative preference shares: the dividend does not accumulate; if it is not paid in a year, the right to it is lost.
• Participating preference shares: besides the fixed dividend, the holders share in the surplus profits of the company.
• Non-participating preference shares: the holders receive only the fixed dividend and do not share in surplus profits.
• Convertible preference shares: the holders may convert their shares into equity shares after a stated period.
• Redeemable preference shares: the company repays these shares after a stated period.

Kinds of debentures

Debentures are of several kinds:

• Secured debentures: these are charged on the assets of the company, so the holders can recover their money from those assets if the company fails to pay.
• Unsecured debentures: these have no charge on assets and depend only on the general credit of the company.
• Redeemable debentures: these are repaid by the company after a stated period.
• Irredeemable debentures: these are not repaid during the life of the company and are repaid only on winding up.
• Convertible debentures: these may be converted into equity shares after a stated period.
• Non-convertible debentures: these remain debentures and cannot be converted into shares.

How do the short-term sources compare?

The three bank facilities differ in their security, their use and the way interest is charged. The table below compares them.

All three are short-term sources, so they are used to meet working capital needs rather than to buy fixed assets.

A business that needs to hold stock may use cash credit, one that needs to meet a temporary shortage may use an overdraft, and one that holds a bill of exchange may discount it to get money before the due date.

The common thread is that each facility is meant to be repaid or settled within a short period, usually within a year. None of them is suitable for buying a factory or machinery, because the money must be returned long before such an asset earns back its cost. A business that mixes them up may find itself short of cash when the bank asks for repayment.

Interest is the main cost of each facility, and the way it is charged differs. In cash credit the borrower pays only for the amount drawn, so an unused limit costs nothing. In an overdraft the charge falls on the amount by which the account is overdrawn. In discounting, the charge is the discount deducted from the bill at the time of sale, so the borrower receives less than the face value of the bill.

Glossary

• Capital market: the market for long-term funds, where savings are mobilised through shares, debentures and government securities.
• Primary market: the part of the capital market where a company issues new securities to investors for the first time.
• Secondary market: the stock exchange, where securities already issued are bought and sold among investors.
• Share: a unit of the capital of a company that makes its holder a part-owner.
• Shareholder: a person who holds shares in a company and is a part-owner of it.
• Dividend: the return paid to shareholders out of the profits of the company.
• Equity share: an ordinary share carrying ownership, voting rights and a dividend that varies with profits.
• Preference share: a share carrying a fixed dividend and priority in repayment over equity shares.
• Debenture: a written acknowledgement of a loan to a company, carrying a fixed rate of interest.
• Debenture holder: a creditor of the company who holds debentures and receives fixed interest.
• Cash credit: a bank facility allowing a borrower to withdraw up to a limit against the security of stock.
• Overdraft: a facility on a current account allowing the holder to withdraw more than the balance up to a limit.
• Discounting of bills: selling a bill of exchange to a bank before its due date for less than its face value.

Common errors and misconceptions

• Misconception: A debenture holder is an owner of the company. Correct: A debenture holder is a creditor, because a debenture is a loan, not a share of ownership.
• Misconception: Dividend on equity shares is fixed. Correct: Equity dividend varies with profits, while preference dividend is fixed.
• Misconception: Interest on debentures is paid only when the company earns a profit. Correct: Interest is a charge and must be paid whether or not there is a profit.
• Misconception: The capital market deals in short-term funds. Correct: The capital market deals in long-term funds; short-term needs are met by banks.
• Misconception: In cash credit, interest is charged on the whole sanctioned limit. Correct: Interest is charged only on the amount actually used.
• Misconception: Discounting of bills means the bank lends the full amount of the bill. Correct: The bank pays the amount of the bill less a discount and collects the full amount on maturity.
• Misconception: Preference shareholders always receive their dividend. Correct: The dividend is paid only when there are profits, though it has priority over equity dividend.

Exam-style questions with model answers

Q1. State the meaning of the capital market. [2 marks]

1. The capital market is the market for long-term funds.
2. It mobilises savings and makes them available to companies and governments through shares, debentures and government securities.

Q2. State any two functions of the capital market. [2 marks]

1. It mobilises savings from households and channels them into productive investment.
2. It provides liquidity through the secondary market, so investors can sell securities before maturity.

Q3. Distinguish between equity shares and preference shares on any three bases. [3 marks]

1. Dividend: the dividend on equity shares varies with the profits of the company, while the dividend on preference shares is paid at a fixed rate.
2. Priority: preference dividend is paid before any equity dividend, and preference capital is repaid before equity capital on winding up.
3. Voting rights: equity shareholders have full voting rights at general meetings, while preference shareholders usually vote only on matters that affect their own rights.

Q4. Explain any three differences between shares and debentures. [3 marks]

1. Status: shareholders are owners of the company, while debenture holders are its creditors, because a debenture is a loan.
2. Return: shareholders receive a dividend, which varies with profits and is paid only when there are profits, while debenture holders receive fixed interest whether or not there is a profit.
3. Repayment: equity share capital is not repaid during the life of the company, while debentures are usually repaid after a stated period.

Q5. Explain cash credit and overdraft as short-term sources of finance. [4 marks]

1. Cash credit is a facility under which a bank allows a borrower to withdraw up to a sanctioned limit against the security of stock or other assets.
2. Interest on cash credit is charged only on the amount actually used, and the facility is usually given for a year and renewed.
3. An overdraft is a facility on a current account under which the holder may withdraw more than the balance up to a sanctioned limit.
4. Interest on an overdraft is charged on the amount overdrawn, and it is usually given to traders for short periods.

Q6. Explain the meaning of a debenture and state why a company may prefer to raise money through debentures. [4 marks]

1. A debenture is a written acknowledgement of a loan taken by a company; its holder is a creditor of the company, not an owner.
2. The company pays a fixed rate of interest on it whether or not it earns a profit, and repays the principal after a stated period.
3. Debenture holders have no voting rights, so a company that does not want to share control can raise money without bringing in new owners.
4. Because the interest is paid before any dividend is declared, debentures are often a cheaper source than shares, though the interest must be found even in a year of loss.

Q7. Explain the meaning of discounting of bills as a short-term source of finance. [4 marks]

1. Discounting of bills means selling a bill of exchange to a commercial bank before its due date.
2. The bank pays the holder the amount of the bill less a discount, so the holder gets money at once instead of waiting until the due date.
3. On the due date the bank collects the full amount of the bill from the acceptor.
4. The discount is the bank's charge for the service, and it is the cost of this source to the holder of the bill.

Q8. Explain the meaning and any four functions of the capital market. [5 marks]

1. The capital market is the market for long-term funds, where savings are mobilised and made available to industry and government through the issue and trading of shares, debentures and government securities.
2. Mobilising savings: it collects scattered savings from households and institutions and channels them into productive investment.
3. Providing long-term funds: it supplies companies and governments with capital for fixed assets such as plant, machinery and buildings.
4. Providing liquidity: the secondary market, the stock exchange, lets investors sell their securities whenever they need their money back.
5. Determining prices: the buying and selling of securities on the stock exchange sets their market prices, which guides investors and companies.

Q9. Explain the meaning of shares and describe the two types of shares. [5 marks]

1. A share is a unit of the capital of a company; its holder is a part-owner who receives a dividend that depends on the profits of the company.
2. Preference shares carry a fixed rate of dividend, which is paid before any dividend is paid on equity shares.
3. When the company is wound up, preference shareholders are repaid their capital before equity shareholders.
4. Equity shares are the ordinary shares of the company; their holders are its real owners, with voting rights and a say in management through the general meeting.
5. The dividend on equity shares varies with profits, and equity shareholders bear the greatest risk because they are paid last, but they gain most when the company prospers.

Key takeaways

• The capital market deals in long-term funds and links savers with companies and governments that need capital.
• Its main functions are mobilising savings, providing long-term funds, facilitating issues, providing liquidity and pricing securities.
• Shares are units of ownership; equity shares carry voting rights and a variable dividend, while preference shares carry a fixed dividend and priority.
• Debentures are loans to the company; their holders are creditors who receive fixed interest and have no voting rights.
• Shares and debentures differ in status, return, repayment, risk and effect on control.
• Commercial banks provide short-term finance through cash credit, overdraft and discounting of bills.
• In cash credit, interest is charged only on the amount actually used, not on the whole limit.
• Discounting of bills gives the holder money before the due date, less the bank's discount.

Test yourself

What is the difference between the primary market and the secondary market?

The primary market is where a company issues new securities and receives the money. The secondary market is the stock exchange, where investors buy and sell securities already issued among themselves.

Why is preference dividend called fixed?

It is calculated at a stated rate on the face value of the shares and does not rise or fall with the profits of the company, though it is paid only when there are profits.

Who bears greater risk, an equity shareholder or a debenture holder?

An equity shareholder bears greater risk, because the dividend depends on profits and the capital is repaid last on winding up, while a debenture holder receives fixed interest and is repaid earlier.

Who is a debenture holder?

A debenture holder is a creditor of the company who has lent it money. The holder receives a fixed rate of interest and has no voting rights.

On what amount is interest charged in cash credit?

Interest is charged only on the amount actually used by the borrower, not on the whole sanctioned limit.

What does the bank do with a discounted bill on maturity?

The bank collects the full amount of the bill from the acceptor on the due date, and its earning is the discount it charged when discounting the bill.

Why does a company's control not get diluted when it issues debentures?

Debenture holders are creditors and have no voting rights, so issuing debentures raises funds without bringing in new owners or sharing control.