NCERT MOST IMPORTANT QUESTIONS CLASS – 11 | Business Studies IMPORTANT QUESTIONS | CHAPTER – 8 Sources of Business Finance| EDUGROWN |

NCERT Most important question:

Question 1.
Explain the meaning of finance and its importance in business.
Answer:
Significance of Business Finance: Business is concerned with the production and distribution of goods and services for the satisfaction of the needs of society. For carrying out various activities, business requires money. Finance is the lifeblood of business.

No business firm can carry on its operations smoothly and successfully without the availability of the right amount of funds at the right cost and at the right time. In the absence of finance, the production and selling of goods and services are not possible.

The success of a business enterprise depends, to a great extent. On the manner in which it raises, employs, and disburses its funds. In business, finance is required
(a) for establishing an enterprise
(b) for purchase of fixed assets and current assets, i.e. for carrying on present operations
(c) for expansion, growth, and modernization of business.

In modern business, the significance of business finance has increased due to an increase in the scale of business, use of capital-intensive techniques, shortage of finance, and increase in competition.

Adequate finance provides the following benefits to a business concern:

1. The firm can meet its liabilities in time. Prompt payment of debts helps in raising its credit-standing. As a result, the firm can easily borrow funds as and when necessary.
2. The firm can take advantage of business opportunities For example, it can buy materials in bulk at a low price.
3. The firm can carry on its business smoothly and without any interruptions.
4. The firm can replace its plant and machinery in time, thereby improving the efficiency of its operations.
5. The firm can face recession, trade cycles, and other crises more easily and confidently.
6. The requirement for fixed and working capital increases with the growth and expansion of the business. At times, additional funds are required for upgrading the technology employed so that the cost of production or operations can be reduced.

Question 2.
Explain in brief the various types of business finance and their uses.
Answer:
Types of Business Finance and their uses:
On the basis of nature and purpose served finance used in a business is of the follow ing kinds –
1. Long-term Finance:
Long-term sources fulfill the financial requirement of an enterprise fora period exceeding 5 years. Long-term finance refers to the fundraised for a long period of time. Such finance is used for investment in fixed assets such as land, building, plants, machinery, furniture, fixtures, etc. Fixed assets are those assets that are required for permanent use and are not meant for sale. Long-term finance is used for meeting the permanent needs of businesses. It is used again and again to generate revenue.

Such finance cannot be taken out of the business without closing down the firm or without reducing the scale of operations. Long-term finance is raised from shareholders, debenture holders, financial institutions, and retained earnings. The amount of long-term funds required depends upon the nature and size of the business. For example, a factory requires more long-term funds than a shop.

Similarly, a large factory needs greater long term funds than a small factory. Long-term sources of finance include shares and debentures, long-term borrowings, and loans from financial institutions.

2. Medium-term Finance:
This type of finance is required for investment in permanent working capital and for repayment of assets. It is also used for modernization and expansion. It is raised for a period of more than one year but less than five years. Medium-term finance is raised from debenture holders, financial institutions, public deposits, and commercial banks.

3. Short-term Finance:
Short-term funds are those which are required for a period of not exceeding one year. It is used for meeting the short-term needs of the business. It is also known as working capital. Working capital is the capital required for meeting the day-to-day needs of the business, e.g. purchase of materials and payment of wages, salaries, rent, taxes, freight charges, etc. short-term finance is raised from public deposits, commercial banks, trade credit, factoring, customer advances, etc.

Short-term funds can be used over and over again from year to year. Seasonal businesses that must build inventories in anticipation of selling requirements often need short-term financing for the interim period between seasons. Wholesalers and manufacturers with a major portion of their assets tied up in inventories or receivables also require a large number of funds for a short period.

Question 3.
What is the term Trading on Equity? Explain with the help of an example.
Answer:
Trading on Equity:
Trading on equity is an arrangement under which the management raises funds by issuing securities that carry a fixed rate of interest or dividend which is less than the average earnings of the company to increase the return on equity shares. If a company can earn more than the rate of fixed dividend or interest, excess earnings will goto equity shareholders; and they would thereby earn higher earnings per share than they would have without the use of gearing of capital structure.

For instance, Mahindra company has an equity capital of Rs.40,00,000, and Kodak company has an equity capital of Rs. 16,00,000 and 15% debentures of Rs.24,00,000. Both have earnings of Rs. 10,00,000 which is 25% on the total capitalisation of Rs.40,00,000. Assuming the tax rate of 50% on corporate income, the shareholders of Kodak company will have the benefit of trading on equity. Their return is 20% compared to 12.5% in the case of Mahindra Company as shown in Table.

Question 4.
Differentiate between Equity Share and Preference Share
Answer:
Difference between Equity Share and Preference Share:

Basis	Equity Share	Preference Share
1. Preferential Right	Payment of equity dividend is made after the payment of preference dividend.	Payment of preference dividend is made before the payment of equity dividend. They have priority over equity shares.
2. Repayment of Capital at Winding-up	Repayment of equity share capital is made after the repayment of prtf&n share capital.	Repayment of preference share capital is made before the repayment of equity share capital. They have priority over the refund of capital.
3. Rate of Dividend	The rate of equity dividend may vary from year to year depending upon the profits of the company.	The rate of preference dividend is fixed by the terms of the issue.
4. Arrears of Dividend	In the case of equity shares, arrears of dividend cannot accumulate. It fluctuates with profit.	In the case of preference shares. arrears of dividend may accumulate if such shares are cumulative.
5. Convertibility	Equity shares cannot be convertible.	Preference shares may be convertible into equity shares.
6. Redeemability	Equity shares are not redeemable during the lifetime of the company	Preference shares are redeemable during the lifetime of the company or at a specific time mentioned.
7. Premium on Redemption	They cannot carry a right to receive a premium on redemption.	They may carry a right to receive a premium on redemption.
8. Voting Rights	Equity shareholders enjoy voting rights ¡n the general meetings of shareholders. These shareholders have full voting rights.	Preference shareholders do not have any voting rights except all the meetings of preference shareholders. Voting rights of preference shareholders are restricted.
9. Degree of Risk	Sink and swim with the company.	Relatively less risk.
10. Appeal to investors	Attractive to bold and adventurous investors.	Appeal to conservative and orthodox investors.

Question 5.
Differentiate between Shares .and Debentures.
Answer:
Difference between Share and Debentures:

Point of Distinction	Shares	Debentures
1. Nature	Part of capital. owned funds of the company.	Debt or loan, borrowed funds and is an acknowledgment of debt.
2. Status of Holders	Owners of the company.	Creditors of the company.
3. Right to return	Dividends cannot be claimed as a matter of rights.	Interest can be claimed as a matter of right.
4. Security	No charge on assets or mortgage as security.	Generally a charge on assets as security to mortgage.
5. Voting rights	Full voting rights	No voting rights and say in the management.
6. Redemption	Not repayable during the lifetime of a company (except redeemable preference shares)	Generally repayable after a specified period.
7. Order of repayment	After all claims of creditors are settled	Prior to all types of shareholders.
8. Frequency of return	Uncertain and fluctuating depending on profits.	Absolutely certain or fixed irrespective of profits.
9. Risk to holders	The complete risk is borne by holders.	Minimum risk in case of secured debentures.
10. Charge in accounts	Dividend on shares ¡s a charge against profit and loss appropriation account	Interest on debentures is a charge against profit and loss account.

Question 6.
Explain the term Lease-financing. Give in brief its merits and limitations.
Answer:
Lease-financing:
A lease is a contractual agreement in which one party i.e. the owner of an asset grants the other party the right to use the assist in return for a specific period for payment. The owner of the assets is called the lessor while the other party that uses the assets is known as the lessee.

Lease financing provides an important means of modernization and diversification to the firm. Such type of financing is more prevalent in the acquisition of assets like computers and electronic equipment which becomes obsolete quicker because of fast-changing technological developments.

Following are the merits of lease-financing:
(a) It enables the lessee to acquire the asset with a lower investment.
(b) It provides finance without diluting the ownership or control of the business.
(c) The lease agreement does not affect the debt raising capacity of an enterprise.
(d) The risk of obsolescence is born by the lesser. This allows greater flexibility to the lessee to replace the asset.

Limitations:
The limitations of lease-financing are as under –

1. A lease arrangement may impose restrictions to allow the lessee to make any alteration or modification in the asset.
2. It may result in higher payout obligation in case the equipment is not found useful and the lessee opts for premature termination of the lease agreement.
3. The lessee never becomes the owner of the assets. It depriver him of the residual value of the assets.

Question 7.
Classify the sources of funds on the basis of ownership.
Answer:
On the basis of ownership the sources of fund are divided into two types:

1. Owner’s capital,
2. Borrowed capital.

Owner’s capital or Owner’s fund: The capital of the owner of the business falls under this category.

It is got from three resources:

1. Equity shares,
2. Preference shares and
3. Retained earnings.

Features:

1. Owner funds are treated as risk capital i.e., provision of loss, low profits, etc.
2. Owned funds are the permanent source of capital.
3. Owners fund different front management.
4. There is no need for security for the owner’s fund.

Advantages:

1. Owner’s capital forms the basis for raising loans.
2. It is the permanent source of capital.
3. This management is separate from ownership. Therefore professional managers can be employed to work efficiently.
4. Capital forms the basis on which owner acquire their rights to control the activities of the company.
5. In this type of capital, no security is required, the assets of the company are free to be used for raising loans.

Borrowed funds: Funds obtained from the parties, separate from the owner of an enterprise are known as borrowed funds:

1. Borrowed funds can be raised for a specific period.
2. There must be security for raising funds through debentures.
3. A fixed charge is made on assets due to borrowing funds.
4. Borrowed funds are payable after the specific period.
5. There is much control on the company due to the non-interference of creditors.

Advantages:

1. It does not affect the owner’s control over management.
2. Interest is treated as an expense. Therefore the amount of tax liability is reduced.
3. It provides flexibility to the capital structure. Finance may be raised when it is required and repaid when it is not required.

Limitations:

1. Payment of interest and repayment of the loan cannot be avoided even if there is no profit.
2. It requires securities to be offered against the loans.

Question 8.
What is Trade Credit? State its merits and limitations?
Answer:
Trade credit is the credit extended by one trader to another for the purchase of goods and services. It is used as short term financing. It is granted to those parties which have a sound financing position and goodwill. The volume and period of the credit depending upon various factors such as goodwill of the purchasing firm, the financial position of the seller, volume of purchases, past record of payment, and degree of competition in the market.

Merits:
The following are the merits of trade credit:

1. It is a convenient and regular source of funds.
2. It may be readily available in case the creditworthiness of the customers is known to the seller.
3. It does not create any charge on the assets of the firm.
4. It promotes the sales of an organization.
5. It helps in increasing the stock in order to meet expected demand in the sales volume in near future.

Limitations:

1. Easy availability may induce a firm to “indulge in overtrading.
2. Only a limited amount of funds can be generated.
3. It is a costly source of funds as compared to others.

Question 9.
Explain Commercial Banks and Financial Institutions as a source of business finance.
Answer:
Commercial Banks:
Commercial Banks are a very important source of finance. They provide funds for different purposes and for different periods. They provide loans to all firms and finance them by the way of cash credits, overdraft, purchase/selling, and the issue of letters of credit. The Interest rate depends upon the type of loan and the interest rate of an economy. The loan is repaid either in a lump sum or in installments. The borrower is required to provide some security or create a change on the assets of the firm before a loan is sanctioned by a commercial bank.

Merits:

1. They provide timely finance as and when needed by the business.
2. Information supplied to the bank by the firm is kept confidential, so the secrecy of the firm can be maintained.
3. Not many formalities required like an issue of prospectus and underwriting for raising loans from banks.
4. The loan from a bank is a flexible source of finance, a loan is taken as and when required and repaid in advance when funds are not needed.

Limitations:

1. Funds available from the bank generally for a short and medium period.
2. The procedure of obtaining funds from banks is slightly difficult because the bank makes a detailed investigation of the company affairs and may ask for the security of assets and personal securities.
3. In some cases, difficult terms and conditions are imposed by the bank for the grant of loan which affects the smooth running of the business.

Financial institutions: For the development of industry’s’ and business center and state governments established various financial institutions to provide finance and assistance, They provide both owned capital and loan capital for the long and medium-term. In addition to providing financial assistance, these institutions also conduct market surveys and provide technical assistance and managerial services to people who run the enterprises.

This source of financing is considered suitable when large funds for a larger duration are required for the expansion, reorganization, and modernization of an enterprise.

Merits:

1. They provide long-term finance.
2. They also provide financial, managerial, and technical advice and consultancy to business enterprises.
3. Raising a loan from this institution increases the goodwill of the borrowing company in the capital market.
4. As repayment of the loan can be made in easy installments, it does not prove to be much of a burden on the business.
5. The funds are made available even during periods of depressions.

Limitations:

1. Raising loans from a financial institution is time-consuming and expensive because they follow too many formalities.
2. Certain restrictions are imposed on the power of the borrowing company.

They may have their nominees in the Board of Directors of the borrowing company thereby restricting the powers of the company.

Question 10.
“Finance is the lifeblood of business.” Is this statement true? Explain.
Answer:
Yes, it is true that ‘Finance is the lifeblood of the business. No business firm can carry on its operation smoothly and successfully without the availability of the right amount of funds at the right cost and at the right time. In the absence of finance, the production and selling of goods and services are not possible.

In business, finance is required for:

• establishing an enterprise
• purchase of fixed and current assets
• expansion, growth, and modernization of business.

In modem business, the significance of business finance has increased due to an increase in the scale of business, use of capital-intensive techniques, shortage of finance, and increase in competition.