Sources of Finance – Long Answer Questions
Medium Level (Application & Explanation)
Q1. Explain why finance is called the “life blood” of business. Support your answer with examples from small and large businesses.
Answer:
- Finance is called the life blood because every business activity—starting, running, and expanding—depends on the availability of money.
- It is needed to buy raw materials, pay wages and salaries, settle utility bills, and distribute goods to customers.
- The initial capital of the owner is often not enough; businesses usually need additional funds from other sources to keep operations smooth.
- For a small business like a grocery shop, finance helps in buying stock and paying rent.
- A bakery needs funds for ovens, ingredients, and staff wages.
- A car manufacturer requires huge fixed capital to build factories and buy expensive machinery.
- Without timely finance, businesses face delays, lost sales, and reputation damage.
- Thus, finance ensures continuity, growth, and stability of business operations at all levels.
Q2. Describe fixed capital requirements. What factors determine how much fixed capital a business needs? Give examples.
Answer:
- Fixed capital is the money invested in long-term assets like land, building, machinery, vehicles, and furniture that stay in the business for many years.
- It is used for setting up and expanding production capacity and is generally recovered over time.
- The nature of business affects the amount—manufacturing needs more fixed capital than trading.
- The size of business matters: a large factory needs more than a small shop.
- The level of technology and automation influences the amount; advanced machines cost more but may reduce labor costs.
- The stage of growth (new setup vs. expansion) and future plans also change fixed capital needs.
- Examples: a textile unit buying looms and setting up a plant; a restaurant purchasing furniture and kitchen equipment; a transport company buying delivery vans.
- Adequate fixed capital builds capacity, productivity, and long-term stability.
Q3. What is working capital? Explain its components and why every business needs adequate working capital, with suitable examples.
Answer:
- Working capital is the money used for day-to-day operations like buying materials, paying wages, rent, electricity, and other routine expenses.
- It is tied up in current assets such as cash, stock-in-trade (inventory), and bills receivable (debtors).
- Businesses need adequate working capital to ensure smooth production, timely payments, and steady sales.
- If working capital is insufficient, firms may miss supplier discounts, delay wages, lose orders, or face stock-outs.
- Examples: a bakery buying flour, sugar, eggs daily and paying staff; a shop paying rent and utilities; a factory paying monthly wages and purchasing raw materials.
- Higher sales seasons (e.g., festivals) require extra working capital to hold more stock.
- Proper working capital management improves liquidity, creditworthiness, and customer satisfaction.
Q4. Classify sources of funds on the basis of period. Explain long-term, medium-term, and short-term sources with their common uses and examples.
Answer:
- On the period basis, funds are classified as long-term, medium-term, and short-term, based on how long the money is needed.
- Long-term sources (more than 5 years): used for buying land, building, and expensive machinery. Common sources: issue of shares, debentures, and long-term bank or institutional loans.
- Medium-term sources (1–5 years): used for vehicles, renovations, or equipment upgrades. Common sources: term loans from banks, hire purchase, or leasing.
- Short-term sources (less than 1 year): used for daily expenses and seasonal needs. Common sources: trade credit, bank overdraft, short-term loans, and commercial papers (for larger firms).
- Examples: building a new office (long-term), buying delivery vans for 3 years (medium-term), purchasing raw materials before a festival (short-term).
- Matching the duration of need with the source helps control cost and risk.
Q5. Differentiate between owner’s funds and borrowed funds. Explain their features, common sources, and when each should be used.
Answer:
- Owner’s funds are contributed by the owners (sole trader, partners, or shareholders). They include share capital and retained earnings.
- Features: provide risk capital, involve ownership and control, no compulsory interest, but may dilute control if new shares are issued.
- Use when: building strong base capital, absorbing risks, or avoiding fixed repayment pressure.
- Borrowed funds are raised from outsiders and must be repaid with interest. They include bank loans, financial institution loans, debentures, public deposits, and trade credit.
- Features: do not dilute ownership, create fixed obligations, may require collateral, and increase financial risk if overused.
- Use when: owners want to retain control, need funds quickly, or wish to leverage growth.
- Balanced use of both ensures stability, control, and cost-effective finance.
High Complexity (Analytical & Scenario-Based)
Q6. A notebook manufacturing startup needs a building and machines for 10 years, vans for 3 years, and monthly funds for paper and wages. Design a suitable financing plan and justify each choice.
Answer:
- For the building and machines (10 years), use long-term finance such as issuing shares (for equity base) and long-term bank/financial institution loans or debentures. This matches the long life of assets and spreads repayment over many years.
- For vans (3 years), choose medium-term finance like a 3-year term loan, hire purchase, or leasing. These options align with the asset’s useful life and keep payments manageable.
- For monthly working needs (paper, wages), use short-term finance such as trade credit from suppliers, bank overdraft, or a working capital limit. These are flexible and cost-effective for fluctuating needs.
- This plan follows the matching (hedging) principle—use long-term funds for long-term assets and short-term funds for short-term needs—reducing liquidity risk and refinancing pressure while keeping costs in control.
Q7. A business owner wants to modernize equipment but retain full control. Evaluate the options and recommend the best mix of sources.
Answer:
- The owner should avoid issuing new shares, as that can dilute ownership and control.
- Priority 1: Use retained earnings (ploughed-back profits) if available. This is an owner’s fund that maintains control and has no interest cost, though it depends on past profitability.
- Priority 2: Take borrowed funds such as a term loan from a bank or financial institution. This keeps ownership intact but adds interest and repayment obligations; collateral may be needed.
- Consider equipment leasing as an alternative to reduce upfront cash outflow and match payments to cash inflows from upgraded productivity.
- Keep an eye on interest rates, cash flow coverage, and debt-equity ratio to ensure financial safety.
- Recommendation: Use a mix of retained earnings + medium-term loan or lease, so the business gets modern equipment, maintains full control, and manages costs and risks responsibly.
Q8. Compare the working capital needs of a bakery and a car manufacturing company. Which one needs more and why?
Answer:
- A bakery has a short production cycle, fast-moving inventory (flour, sugar, eggs), and many cash sales. Its working capital turns over quickly, and stocks are replenished daily. It needs steady but modest working capital to meet daily expenses and small stock levels.
- A car manufacturer has a long production cycle, heavy investment in raw materials and work-in-progress, and often offers credit to dealers. Inventory is high-value and moves slower.
- Fixed overheads like factory wages, utilities, and testing also add to ongoing cash needs.
- Therefore, in absolute terms, the car manufacturer needs much higher working capital due to longer cycles, larger inventories, and higher per-unit value.
- However, in terms of speed of turnover, the bakery rotates its working capital faster, improving liquidity.
- The difference arises from scale, production time, inventory value, and credit policies.
Q9. A retailer wants extra stock before Diwali and will sell it within two months. Compare short-term options—trade credit, bank overdraft, and short-term loan—and choose the best one with reasons.
Answer:
- Trade credit: Suppliers allow deferred payment. It is often interest-free for the credit period, quick to arrange, and tied to purchase volume. Best if the retailer has a good track record with suppliers. Limits depend on supplier confidence.
- Bank overdraft: Flexible facility to withdraw more than the account balance up to a limit. Interest is paid only on the used amount. Good for fluctuating daily needs and quick repayments as sales come in. Requires bank relationship and may need collateral.
- Short-term loan: Fixed amount and tenure, with fixed interest. Useful when a specific lump sum is required, but less flexible if sales occur earlier than expected.
- Best choice: Start with trade credit to minimize cost, supported by a bank overdraft for flexibility during peak days. This combo keeps costs low, ensures timely stocking, and matches cash inflows from festival sales.