Meaning and Classification of Sources of Finance

Having studied what business finance is and how much fixed and working capital a firm may need, the natural next question this chapter of the Andhra Pradesh Intermediate Commerce syllabus takes up is: from where does a business actually get this money? The various means through which a firm raises the funds it requires are together called the sources of finance.

Sources of finance can be classified in more than one way, and an AP Intermediate first-year Commerce student is expected to know the two most important classifications used in practice.

The first classification is on the basis of ownership, which divides sources into owned funds and borrowed funds. Owned funds (also called owner's capital) are contributed by the owners of the business themselves — a sole trader's own capital, a partner's capital, or, in a company, equity share capital, preference share capital and profits retained in the business (reserves and surplus). Owned funds do not create a fixed liability to pay a return every year, do not usually have to be repaid during the life of the business, and give the contributor either full ownership rights (equity) or a preferential but limited claim (preference capital). Borrowed funds, on the other hand, are raised from outsiders who are not owners of the business — through debentures, loans from banks and financial institutions, public deposits, and trade credit. Borrowed funds create a fixed obligation to pay interest, regardless of whether the firm earns a profit, and must ordinarily be repaid within an agreed period; lenders of borrowed funds generally have no voice in the management of the business.

The second classification is on the basis of the period for which the funds are needed, which divides sources into long-term sources, medium-term sources and short-term sources. Long-term sources (funds needed for more than five years, typically to buy fixed assets) include equity shares, preference shares, retained earnings, debentures and long-term loans from financial institutions. Medium-term sources (funds needed for one to five years) include medium-term loans from banks, and some debentures and public deposits issued for such a period. Short-term sources (funds needed for less than one year, mainly to meet working capital needs) include trade credit, bank overdraft and cash credit, and short-duration public deposits.

An AP Board Intermediate Commerce answer on this chapter typically combines both classifications — first stating whether a source is owned or borrowed, and then whether it meets a long-term, medium-term or short-term need — because a firm plans its total finance by picking a suitable mix from both dimensions at once.