GSEB Class 11 Organization of Commerce and Management Solutions Chapter 8 Sources of Business Finance

1. Select The Correct Alternative And Write Answers To The Following Questions :

 

Question 1. out of the following which is not a source of ownership capital?
(a) Ordinary equity share
(b) Sweat equity share
(c) Preferences share
(d) Debenture
Answer: (d) Debenture
In simple words: Debentures are a type of loan, not money owned by the company's owners. They are a form of borrowed capital, meaning the company needs to pay it back.

Exam Tip: Remember that ownership capital represents the funds contributed by the actual owners of the business, while debentures signify borrowed capital, creating a debt for the company.

 

Question 2. Who are called the true owners of company?
(a) Equity share holder
(b) Preference share holder
(c) Debenture holder
(d) Bond holder
Answer: (a) Equity share holder
In simple words: Equity shareholders own a part of the company and have voting rights, making them the real owners who take on the biggest risks.

Exam Tip: Equity shareholders bear the maximum risk and benefit most from the company's success, hence they are considered the true owners.

 

Question 3. Which shares are offered to the managers at a discounted price or instead of cash?
(a) Ordinary equity share
(b) Sweat equity share
(c) Bonus share
(d) Rights share
Answer: (b) Sweat equity share
In simple words: Sweat equity shares are given to employees or directors as a reward for their special skills or hard work, rather than for a direct cash payment.

Exam Tip: Sweat equity shares are distinct from other share types as they recognize contributions beyond financial investment, such as intellectual property or expertise.

 

Question 4. Who has the first right to receive dividend from profit of company?
(a) Preference share-holders
(b) Debentures holders
(c) Equity share-holders
(d) Creditors
Answer: (a) Preference share-holders
In simple words: Preference shareholders get their dividends first, before anyone else, because they hold a special right to that part of the company's profits.

Exam Tip: The term 'preference' itself indicates that these shareholders have priority over equity shareholders in receiving dividends and capital repayment during liquidation.

 

Question 5. At time of liquidation who gets capital first?
(a) Preference share-holders
(b) Ordinary equity share-holders
(c) Promoters
(d) Debentures holders
Answer: (d) Debentures holders
In simple words: When a company closes down, debenture holders are paid back their money before anyone else because they are considered creditors of the company.

Exam Tip: In the hierarchy of claims during liquidation, creditors (including debenture holders) are always paid before any shareholders.

 

Question 6. The capital invested in the assets of capital is known as which capital?
(a) Working capital
(b) Short time capital
(c) Current capital
(d) Fixed capital
Answer: (d) Fixed capital
In simple words: Money put into long-lasting things like land or buildings is called fixed capital because these assets are not used up quickly.

Exam Tip: Fixed capital finances long-term assets, providing a stable base for operations, while working capital covers day-to-day expenses.

 

Question 7. What are the debenture holders of the company called?
(a) Owners
(b) Debtors
(c) Creditors
(d) Promoters
Answer: (c) Creditors
In simple words: Debenture holders are called creditors because they lend money to the company and expect to be paid back with interest.

Exam Tip: Debenture holders are lenders, not owners, and their claim is a debt against the company's assets, making them creditors.

 

Question 8. Is the internal source to satisfy the long term finance requirements for business unit.
(a) Ordinary Equity shares
(b) Preference share
(c) Public deposits
(d) Ploughing back of profits
Answer: (d) Ploughing back of profits
In simple words: When a company uses its past earnings to fund its future plans, instead of paying them out, this is an internal way to get long-term money.

Exam Tip: Internal sources of finance like retained earnings (ploughing back of profits) are crucial for long-term growth as they do not incur external debt or equity dilution.

 

Question 9. Which companies can plough back the profits?
(a) New establishing company
(b) Running company
(c) Financially sound company
(d) Loss making company
Answer: (c) Financially sound company
In simple words: Only companies that are doing well financially and making profits can choose to reinvest those profits back into their business.

Exam Tip: Profit ploughing back is a strategy available only to profitable companies as it involves retaining earnings rather than distributing them to shareholders.

 

Question 10. How does the government get finance to implement long term project?
(a) By ordinary share
(b) By bond
(c) By debentures
(d) By public deposits
Answer: (b) By bond
In simple words: Governments usually get money for big, long-term projects by selling bonds, which are like loans they promise to pay back with interest.

Exam Tip: Bonds are a common and effective method for governments to raise large sums of money for infrastructure and long-term development projects.

 

Question 11. The proper source of getting short term working capital is
(a) Preference share
(b) Bond
(c) Financial institution
(d) Trade credit
Answer: (d) Trade credit
In simple words: Trade credit is a good way for businesses to get short-term money by buying goods now and paying for them later.

Exam Tip: Trade credit is an informal and accessible source of short-term finance, often used to manage immediate working capital needs without formal borrowing.

 

2. Answer The Following Questions In One Sentence Each :

 

Question 1. Which shareholders are the true owners of business?
Answer: Equity shareholders are considered the true owners of a business.

Exam Tip: Always specify "equity shareholders" as they hold residual claim and voting rights, differentiating them from preference shareholders.

 

Question 2. Who has the first right to receive dividend from company's profit?
Answer: Preference shareholders have the first right to receive dividends from a company's profits.

Exam Tip: Remember that preference shares are named for their priority in dividend distribution over equity shares.

 

Question 3. State the sources of borrowed capital.
Answer: Borrowed capital can be raised primarily through:

• Debentures
• Bonds
• Public deposits
• Loans from financial institutions
• Commercial banks
• Trade credit and
• Internal deposits.

In simple words: Companies get borrowed money from many places like debentures, bonds, public deposits, bank loans, and trade credit.

Exam Tip: List a variety of sources to show comprehensive knowledge, categorizing them mentally into long-term (bonds, debentures) and short-term (trade credit, public deposits).

 

Question 4. What is a convertible debenture?
Answer: If a company has declared that, after a specific time, debentures will be converted entirely or partly into equity shares, then such debentures are called convertible debentures.
In simple words: Convertible debentures are special loans that can turn into company ownership shares after some time.

Exam Tip: Highlight the key feature: the option to convert into equity shares, which is attractive to investors seeking both debt security and potential equity upside.

 

Question 5. Explain the following terms :
(1) IFCI
(2) IDBI
(3) ICICI
(4) GSFC
(5) GIIC
Answer: The full forms for the abbreviations are as follows:
(1) IFCI (Industrial Finance Corporation of India)
(2) IDBI (Industrial Development Bank of India)
(3) ICICI (Industrial Credit and Investment Corporation of India)
(4) GSFC (Gujarat Slate Finance Corporation)
(5) GIIC (Gujarat Industrial Investment Corporation)
In simple words: These are the full names for important financial institutions in India that help industries and businesses with money.

Exam Tip: Ensure precise recall of each full form, paying attention to specific terms like "Finance," "Development," "Credit and Investment," and geographical tags like "Gujarat Slate" and "Gujarat Industrial."

 

Question 6. State the main lending polices of commercial banks.
Answer: Banks carefully analyze a business's financial requirements, its capacity to repay loans, income tax returns, past and current accounts, and profit records. If the bank is satisfied, it can provide funds through loans, cash credit, and overdraft facilities.
In simple words: Banks check a business's money needs, its ability to pay back, tax history, and profits before giving loans like cash credit or overdrafts.

Exam Tip: Focus on the comprehensive due diligence process of banks, including financial assessment and creditworthiness, before sanctioning any lending facility.

 

3. Answer The Following Questions In Short :

 

Question 1. Give meaning of capital from the view of commerce.
Answer: Business finance:

• The term 'capital' has a restricted scope when one discusses it in accounting. According to accounting principles, capital is money invested, goods, and assets when grouped together.
• Commerce has a broader meaning for capital. In commerce, capital includes the owner's invested money and funds borrowed from various financial sources. Therefore, capital means 'funds raised to meet the diverse financial requirements of the business'.

In simple words: In business, capital means all the money and assets a company has, whether from owners or loans, used to run the business.

Exam Tip: Clearly distinguish between the narrow accounting definition of capital and the broader commercial definition, emphasizing that the latter includes both owned and borrowed funds.

 

Question 2. What is called sweat equity share?
Answer: Equity shares given by a company to its directors or employees at a lower price or for contributions other than cash, like their specialized knowledge and skills provided to the company, are known as sweat equity shares.
In simple words: Sweat equity shares are given to employees or directors for their hard work or special skills, not for cash, and often at a cheaper price.

Exam Tip: Emphasize that sweat equity is issued for non-cash consideration, specifically for intellectual property or valuable services, rather than monetary investment.

 

Question 3. Why preference shares are called the share of preference?
Answer: Shares that receive the first priority to get dividends and, during liquidation, the first right to receive back capital are called preference shares. Since these shares get the primary preference to receive dividends and claim capital, they are named preference shares.
In simple words: Preference shares are called that because their holders get paid dividends first and also get their money back before others if the company closes.

Exam Tip: The two key "preference" aspects are priority in dividend payment and priority in capital repayment during liquidation. Mentioning both ensures a complete answer.

 

Question 4. State types of preference share.
Answer:

• Preference shares that can be redeemed before 20 years and
• Preference shares that can be redeemed after 20 years.

In simple words: Preference shares can be redeemed either within 20 years or after 20 years.

Exam Tip: Always categorize preference shares based on their redemption period, specifically noting the 20-year benchmark.

 

Question 5. Why ordinary equity share is called risky share?
Answer:

• The purchasers of equity shares assume a significant amount of risk by acquiring these shares.
• They understand that the market price of shares may fall. They also know that they may or may not receive dividends, and the dividend amount will never be fixed.
• In the event of liquidation, after the company settles all its debts, if any money remains, only then will it return capital to equity shareholders.
• Due to the various risks that equity shareholders undertake and still remain committed to the company as investors, they are known as the true owners of the company.

In simple words: Equity shares are risky because their price can go up or down, dividends are not guaranteed, and they are the last to get paid if the company fails.

Exam Tip: When explaining risk, cover price volatility, uncertain dividends, and the residual claim in liquidation for equity shareholders.

 

Question 6. What is the main difference between bond and public deposits?
Answer: Bonds and public deposits represent two distinct ways for companies to raise funds. Bonds are long-term debt instruments usually issued by governments, municipalities, or large corporations to secure significant capital. They often carry a fixed rate of interest and can be traded in financial markets, providing investors with liquidity. In contrast, public deposits are typically short-to-medium term funds collected directly from the public by companies, usually for periods ranging from six months to three years. These deposits are generally unsecured, meaning they are not backed by specific assets of the company, unlike some bonds which can be secured. While both offer fixed interest, bonds offer better liquidity and often have longer maturities compared to public deposits, which are non-transferable and primarily used for meeting working capital needs.
In simple words: Bonds are long-term loans for big projects, often traded like shares. Public deposits are shorter loans from the public, usually unsecured, and used by companies for quick cash needs.

Exam Tip: When distinguishing between financial instruments, always compare their term, security, interest characteristics, and whether they are transferable or not.

 

Question 7. What is a floating charge?
Answer: Floating charge:

• A company uses a floating charge to borrow capital against debentures. It is a charge on the company's assets. The charge moves freely across the property that is to be covered.
• A unique feature of the floating charge is that the company can continue to use these assets even when they are mortgaged for debentures.

In simple words: A floating charge is a type of security for a loan where a company can still use the assets that are mortgaged.

Exam Tip: The key characteristic of a floating charge is that it hovers over a class of assets, allowing the company to trade or dispose of them until a default occurs, at which point it crystallizes into a fixed charge.

 

4. Answer The Following Questions In Brief :

 

Question 1. Explain advantages and limitations of ordinary equity share.
Answer: Advantages of ordinary shares:

• Shareholders or investors who buy these shares are considered the true owners of the company.
• Shareholders can earn good dividends.
• Shareholders have the right to attend general meetings and the right to vote and elect directors.
• The prices of these shares fluctuate frequently, allowing one to make good money by trading them in the share market.
• Shareholders may also receive bonus shares from the company.

Disadvantages of ordinary shares:

• Owners of ordinary shares face a high risk of share price fluctuations in the market.
• In case of company liquidation, they are the last to receive their capital invested in the shares.
• They may not receive any dividend, or they may receive very little dividend.
• Even though they have voting rights, small investors might not be able to influence company management due to the dominance of directors and large investors. Shareholders can become victims of speculation.

In simple words: Equity shares offer ownership, voting rights, and potential for high dividends and trading gains, but they also come with high price risk, uncertain dividends, and are last in line during liquidation.

Exam Tip: Structure your answer by clearly separating advantages and disadvantages, using bullet points for clarity. For advantages, focus on ownership rights and potential returns; for disadvantages, highlight the risks and lack of priority.

 

Question 2. Distinguish between equity share capital a preference share capital.
Answer:

In simple words: Equity shares offer ownership and voting rights with higher risk and variable dividends, while preference shares offer fixed dividends and less risk but usually no voting rights.

Exam Tip: When comparing, create a clear table with distinct points of difference like compulsion, dividend rate, rights, risk, investor interest, market price stability, and capital addition, providing specific characteristics for each type.

 

Question 3. Explain the lending policy of commerical bank.
Answer: Banks thoroughly analyze a business's financial requirements, its capacity to repay, income tax returns, old and current accounts, and profit records. If the bank is satisfied with these factors, it can extend funds in the form of loans, cash credit, and overdraft facilities.
In simple words: Commercial banks lend money after carefully checking a business's finances, its ability to pay back, tax history, and current profits, offering loans, cash credit, or overdrafts.

Exam Tip: Emphasize the detailed due diligence process banks follow, focusing on financial health, repayment capacity, and historical performance as key decision-making criteria.

 

Question 4. Distinguish between ownership capital a burrowed capital.
Answer:

In simple words: Ownership capital comes from owners and retained profits, offering variable returns and repaid last. Borrowed capital comes from loans (like debentures or banks), offers fixed returns, and is repaid first.

Exam Tip: Clearly define each type of capital and then use a comparative table to highlight key differences such as source, return nature, risk, and repayment priority during liquidation.

 

Question 5. Write short notes on.
(A) Bond
Answer: Bonds:

• Bonds are issued just like debentures to raise capital.
• Bonds represent borrowed capital and thus constitute a debt for the company. Bondholders are creditors of the company. Bondholders receive interest at a specific rate and time. At the end of a pre-determined period, the company returns the principal capital to the bondholders.
• Generally, bonds are more expensive than debentures. They serve as a good source of finance for long-term, large-scale projects.
• Companies, municipalities, or even governments can issue bonds, which are then called corporate bonds, municipal bonds, and government bonds, respectively.
• Bonds are identified by the project for which they are issued. For instance, bonds issued by the government for the Sardar Sarovar project were known as Sardar Sarovar Bond.

In simple words: Bonds are like long-term loans issued by companies or governments to raise money, paying back interest at a set rate over time.

Exam Tip: In a short note on bonds, include their nature as borrowed capital, interest payment, repayment structure, and typical issuers to cover the essential aspects.

 

Question 5. (B) Trade credit
Answer: Trade credit:

• When a businessman purchases raw materials, finished goods, etc., from producers or traders and pays after a pre-determined time, he is considered to have obtained trade credit.
• The businessman is essentially buying on credit from other businessmen for some time. This helps the purchasing businessman conserve his working capital and deploy it elsewhere.
• The businessman then settles the payment after a decided period. Here, the creditor does not provide money directly but offers goods on credit, thereby fulfilling the short-term capital requirement.

In simple words: Trade credit means buying goods now and paying for them later, which helps businesses save their immediate cash.

Exam Tip: Emphasize that trade credit is a short-term, informal financing method where payment for goods is deferred, helping businesses manage working capital efficiently.

 

Question 5. (C) Inter-corporate deposits.
Answer: Inter-corporate deposits:

• When a company with surplus funds deposits a portion or all of it in another company, this is called an inter-corporate deposit.
• These types of transactions usually happen between major and minor companies. Such transactions might also occur among various companies owned by a single group. For example, the Tata group owns Tata Teleservices and Timex watches. If needed, Tata Teleservices might provide an inter-corporate deposit to Timex.
• The interest rate and duration of the deposit are set by an agreement. Compared to borrowing from other sources, this form of borrowing is an easier option.

In simple words: Inter-corporate deposits are when one company lends its extra money to another company, often within the same business group, as an easy way to borrow.

Exam Tip: Explain inter-corporate deposits as a short-term borrowing and lending arrangement between companies, often within the same group, and highlight its ease of transaction.

 

Question 6. "Public Deposit is known as Fair Weather friends'-Explain statement.
Answer:

• A fair-weather friend is someone who is friendly or available only when it benefits them.
• People invest money as public deposits in companies when they anticipate guaranteed returns.
• The interest of these depositors is purely to earn by lending money to the company. When the company faces a financial crisis, and if such news or rumors spread in the market, depositors rush to the company to withdraw their money even before the maturity date. This creates financial problems for the company, and thus public deposits are considered fair-weather friends.

In simple words: Public deposits are like fair-weather friends because investors withdraw their money at the first sign of trouble, causing problems for the company.

Exam Tip: Clearly articulate how public deposits are fair-weather by linking investor behavior (withdrawing funds during crises) to the financial instability it causes for the company.

 

Question 7. "Ploughing back of profit is not possible for every company'-Explain statement.
Answer:

• A company retains profits during good business periods.
• A company can only retain profits if its liabilities are not more than its assets. For a new company, a small company, or a financially weak company that makes profits, maintaining its position against strong and established companies is itself a challenge.
• Furthermore, such companies also need to invest more in modernizing, expanding, and innovating their business to establish a strong foothold in the market.
• They also need to distribute dividends to maintain investor confidence and encourage further investment in their company. Hence, retaining profits is not feasible for every company.

In simple words: Not every company can reinvest its profits because small or new businesses might have too many debts, need to spend on growth, or must pay dividends to keep investors happy.

Exam Tip: When explaining why ploughing back profits isn't universal, consider factors like the company's financial health, growth stage, competitive landscape, and the need to satisfy shareholder expectations.

 

5. Answer The Following Questions In Detail :

 

Question 1. Explain the factors deciding the need of capital.
Answer: Need of business finance: A businessman needs capital to conduct all business activities effectively and on time. The following points clarify the need for business finance:
1. For establishing business:

• Several activities must be performed, and documents prepared and submitted to start a business. Expenses are incurred in conducting primary and detailed research, preparing documents like a certificate of registration and incorporation, etc.
• The businessman also needs to hire experts for legal procedures, registration processes, etc. Businessmen must pay fees and charges at various stages of establishment and also pay fees to these industry experts.

2. For purchasing fixed assets:

• Assets like land, building, furniture, machinery, etc., which are bought for long-term business use and are not likely to be converted quickly into cash, are known as fixed assets.
• One may require substantial long-term finance in terms of loans to acquire these assets.

3. For current assets:

• Once a business is established, it needs working capital, i.e., capital to manage daily expenses. These expenses include salaries and wages, various utility bills, purchasing raw materials, production, and transportation costs, etc.
• Working capital can be raised either by the owner or borrowed as a loan from banks or other sources.

4. For modernization and expansion of business: Scientific innovations and technological advancements occur continuously globally. This results in faster production of newer products and improved quality. A businessman needs to keep pace with these changes to maintain and expand his business. For this, he may have to invest in modern equipment, machinery, and production methods.
5. For unforeseen situations: A business may encounter many unforeseen internal and external factors that could lead to financial crises. For example, strikes, changes in government policies, shifts in the trade cycle, natural calamities, etc., are unforeseen events that necessitate capital reserves.
In simple words: Businesses need money for many reasons: to start up, buy long-term assets like buildings, cover daily running costs, upgrade technology, expand operations, and have emergency funds for unexpected problems.

Exam Tip: Systematically list and explain each factor, from establishment to handling unforeseen events, to provide a comprehensive answer on the need for capital. Use clear headings for each factor.

 

Question 2. Define share and explain the charactristics of equity share.
Answer: Equity shares: An equity share, commonly known as an ordinary share, signifies the fractional or partial ownership of a person, i.e., a shareholder, in the company. Equity shares grant the right to receive dividends (i.e., earn income) according to company laws and the right to claim repayment of share value after the company has made all its payments. After settling all business expenses, taxes, etc., the company may generate profit. Equity shareholders have a right to claim a portion of this profit. The company, based on its policy, may distribute a part of the remaining income as dividends to the shareholders. Equity shareholders have a right to claim this dividend. A company can invite people to buy its shares. The shareholders become part owners, and the company obtains its capital.
Characteristics of equity shares:
1. True owners: Owners of equity shares, i.e., equity shareholders, are considered the company's true owners or loyal companions because they undertake much higher risk by investing in equity shares compared to preference shareholders.
2. Right to vote: Equity shareholders have the right to vote for electing the company's directors. One share equals one vote. Thus, the more shares held, the more votes one can cast.
3. Dividend: Whether to distribute the dividend and how much to distribute depends on the company.
4. Dividend is based on profit:

• The dividend a shareholder receives depends on the profit a company makes.
• A company earning higher profit may distribute a higher dividend, while one making lesser profit or a loss may distribute a smaller dividend or no dividend at all.

5. General meeting: Shareholders have the right to attend general meetings and also have the right to vote and elect the directors.
6. Repayment of capital: Share capital is not returned to the shareholders as long as the company exists. If the company winds up, it returns the share capital after settling all its business debts.
7. Dissolution (Liquidation): At the time of liquidation, the company first settles the capital of preference shareholders and all other business debts, and then if money remains, it pays to equity shareholders.
8. Share qualification: If there is a provision in the memorandum and directors have consented that if a particular person holds a specific number of shares decided by the company, then he can become a director of the company; then the shares are considered as share qualification.
9. Capital benefits: Shareholders receive various capital benefits by owning shares. They earn dividends, the company may also give them bonus shares, and they earn by selling shares whose prices have increased, etc.
10. Registration of shares: Equity shares are registered in recognized share markets or stock exchanges. Investors can freely buy/sell shares in these markets.
In simple words: An equity share means part ownership in a company. Its features include being true owners, having voting rights, dividends depending on profit, attending company meetings, capital repayment only after all debts, potential for bonus shares, and being traded openly.

Exam Tip: Start with a clear definition of an equity share, then list and briefly explain each characteristic. Group related points (like dividend and profit) for better structure.

 

Question 3. Give the meaning of preference share and explain its characteristics.
Answer: Preference shares: The shares that receive the first priority to obtain dividends and, during liquidation, the first right to receive capital back are called preference shares. Types:
(A) Preference shares redeemable before 20 years
(B) Preference shares redeemable after 20 years
In simple words: Preference shares are special shares that get dividends first and have priority for capital repayment if the company closes. They can be redeemed either before or after 20 years.

Exam Tip: Clearly define preference shares by their twin priority rights: dividend payment and capital repayment. Also, remember to mention the main types based on redeemability periods.

 

Question 4. Give the meaning of debenture and explain its types.
Answer:
Debentures:
A debenture is a certificate issued by a company to the public to get money as a loan.

The way a company invites public to buy shares, it can also ask the public to purchase debentures. The main distinction between a share and a debenture is that a shareholder becomes a part owner of the company, while a debenture holder becomes a creditor, from whom the company has taken money as a loan. Debentures are issued when a company requires extra capital but does not wish to issue more shares. The total needed capital is divided into small parts, called debentures, and then the public is invited to subscribe to them. A debenture represents a liability for the company. Buyers of debentures become the company's creditors. The company must pay them interest at pre-decided rates and within a specific period. At the end of the agreed timeframe, the company, based on conditions, returns the entire money to the debenture holders or converts the money into share value and gives shares to the debenture holders. Issuing debentures is a good option for medium-term as well as long-term funding for the company. When a company issues debentures, it appoints trustees who work to safeguard the debenture holders' interests as per the Trust Deed.
Characteristics:
1. Creditors of company: Because a debenture amount is treated as a loan, it represents a company's debt, and debenture holders become the company's creditors.
2. Fixed rate of interest: Debenture holders get interest at a set rate at a specific, agreed-upon time.
3. Fixed burden and charge on asset: Companies offer assets as security to raise capital via debentures. The company must pay interest on these debentures to their holders. This interest acts as a 'fixed charge' on assets or profits, meaning payment is required even if no profit is made. Additionally, the company cannot take out more loans on these assets until the debenture capital is repaid. However, it can still use these assets.
4. Satisfy need: Debentures serve as an effective way to meet needs for medium and long-term funding.
5. Registration at stock-exchange: If debentures are listed on a stock exchange, people can easily trade them, similar to shares.
6. Repayment: At the end of the set period, the company gives back the debenture money to holders, either in one go or in parts, as previously agreed.
7. First preference for payment: As debentures represent company debt, holders are prioritized to receive their money before shareholders when the company dissolves.

Types of debentures:
1. Secured debentures: Debentures secured by company assets are known as secured debentures. This means if the company lacks enough money to repay debentures during dissolution, it will sell the mortgaged assets to make payments. These assets have a floating charge when used as collateral.
2. Convertible debentures: If a company states that debentures will be fully or partly changed into equity shares after a certain time, these are called convertible debentures. If the company's Memorandum of Association includes a rule for converting debentures, then it will offer equity shares for these debentures at a set ratio.
3. Non-convertible debentures: Debentures that cannot be changed into shares, and whose money is returned to holders based on specific terms and a set timeframe, are called non-convertible debentures.
In simple words: A debenture is a company's written promise to pay back a loan with interest. It's a way for companies to borrow money without giving away ownership, and there are different kinds, like those that can become shares or those that are secured by assets.

Exam Tip: When defining financial instruments, always mention if it's ownership or debt, how returns are generated (dividends/interest), and key characteristics like security or convertibility.

 

Question 5. What is the ploughing back of profit? Explain its advantages and limitations.
Answer:
Retained profits OR Ploughing back of profits:
When a company makes good profits during successful business periods, it chooses to save a portion of the total profit, instead of giving it all out as dividends, to meet future business needs. The company can then use these saved profits or retained earnings for growth, investing in new offerings, and other purposes. This reinvested money in the business is known as ploughing back of profit.

Advantages of retained profit:
1. Useful in times of recession: Saved profits can be very helpful during economic downturns, shifts in market trends, and similar situations.
2. Useful in Implementing future plans: These saved earnings help to successfully carry out future plans like business expansion, upgrading equipment and infrastructure, and acquiring assets or extra raw materials. When a company smartly keeps its profits, it avoids relying on outside sources to get funds for these operations.
3. Useful for purchasing new assets: The profits kept back can be used to purchase new and modern assets, such as machines and furniture, to replace older or worn-out ones.
4. Fixed dividend policy: Keeping profits allows a company to create a consistent dividend policy. This helps keep shareholders content and encourages them to invest further in the company.
5. Burden on assets: If a business owner borrows money from financial institutions, like banks, they must use their assets as collateral. If the business can hold onto its earnings, it can keep its assets free from the obligation of a mortgage.
6. Borrowed capital can be repaid: Saved profits can be utilized to pay back money borrowed from banks or other financial organizations.
7. Decrease in cost of capital: When funds are obtained from banks or other financial bodies, interest must be paid on them. This interest is known as the 'cost of capital'. If a company has enough retained earnings, it can use these as capital, thereby avoiding additional capital costs.
8. Owner's funds: Retained earnings are essentially the owner's funds, allowing the business owner to reinvest them into the business and avoid borrowing outside capital or paying interest.

Limitation of retained earnings:
1. Encourages monopoly: When a company keeps too much of its profit, it grows very strong financially. It can then control the market by hoarding raw materials, making vendors and suppliers adhere to its rules, and creating artificial shortages, which leads to a monopoly.
2. Promotes speculation: Sometimes, company directors might give out very small dividends, putting most extra profits into the company's reserves. This might make people think the company is not performing well, causing its share price to drop. The directors could then purchase many shares at low prices and later declare high dividends. Increased dividends would again attract investors, who would begin buying shares. At that point, directors would sell their own shares, making significant personal gains from the trading difference.
3. Difficult for financially weak and new companies: Keeping earnings is either not possible or can only be done on a very small scale for companies that are new or not financially strong. No benefit to small investors: Small investors put money into company shares hoping for large dividends. If directors keep more profits than needed or engage in speculation, small investors might not get dividends or receive very small ones, leading to losses.
In simple words: Ploughing back profit means a company keeps its earnings to reinvest in the business instead of paying them out as dividends. This helps with growth and stability but can sometimes lead to market dominance or create problems for smaller investors.

Exam Tip: When discussing financial strategies like ploughing back profits, always provide both the upsides (advantages) and downsides (limitations) for a balanced answer.

 

Question 6. What is public deposits? Explain advantages and limitations of public deposit.
Answer:
Public deposits:
When a company takes deposits from the public for about 6 to 36 months to meet its short-term financial needs, such as for working capital, the money it gets is known as public deposits. These deposits are borrowed funds and represent a company's debt. Individuals who invest their money as public deposits become the company's creditors. The company pays them a set interest, either quarterly, half-yearly, or upon maturity at the end of the term, along with the principal amount, as agreed. Under the Companies Act, 2013, private companies, except banking and non-banking finance companies, are not permitted to accept public deposits.

Advantages of public deposits:
Easy to obtain: It is quite simple for a strong and profitable company to get funding this way.
Less expensive finance option: Compared to other funding methods, a company can quickly and easily get public deposits with lower costs.
Assets do not have a charge i.e. no need to mortgage assets: A company does not need to use its assets as collateral to get public deposits. This allows it to use those assets for collateral to secure funding from other sources later on.
Interest is an expense: Companies must pay interest on public deposits. This interest counts as an expense and is deducted from profit when preparing accounts for income tax. As a result, a company pays less income tax.
Useful as working capital: Companies can fulfill their short-term working capital requirements by using public deposits.

Limitations:
Uncertainly: Getting public deposits is quite unpredictable. Investors might not want to invest due to their personal choices, habits, or simply a lack of extra money.
Insecurity to investors: Companies do not offer underwriting, unlike for shares and debentures, so investors see it as a risk and feel unsafe. Therefore, public deposits are also known as unsecured debts.
Fair weather friends: If a company faces financial trouble, and this information or rumors spread, depositors quickly go to the company to take back their money, even before it's due. This causes financial difficulties for the company, and so public deposits are seen as 'fair-weather friends'.
Difficult for new and weak companies: Investors generally do not trust new and financially unstable companies much. Therefore, they are unwilling to risk their capital in these businesses. As a result, such companies find it hard to get public deposits.
In simple words: Public deposits are short-term loans companies take from people, offering interest. They are easy to get and inexpensive, but they are uncertain and seen as risky by investors because they are unsecured.

Exam Tip: When describing public deposits, highlight their temporary nature and the fact that they are unsecured, which are key distinguishing features.

 

Question 7. Explain the functions of financial institutions.
Answer:
Functions of financial institutions:
1. Provide finance by buying shares: When a company is being set up, modernized, or expanded, it partners with financial institutions and asks them to purchase its shares. This allows companies to get the required capital from these organizations. Companies might also request these institutions to act as their underwriters, or guarantors.
2. Provide finance by loan: A company can pledge its assets to get loans from these institutions. To meet further financial needs, companies can even use personal property as security to get loans.
3. Help through direct payment for technological services: Sometimes, a company might need to spend a lot on building technology infrastructure or acquiring tech services, such as developing and maintaining its internal network. In these cases, financial institutions make payments to the technology service providers on behalf of the companies.
4. Provide guarantee: A financial institution can agree to guarantee a company, meaning the institution will be responsible for paying the company's debts if the company cannot. This helps the company build trust with investors and other financial institutions to secure funding.
5. Other services: Financial institutions also offer other services, such as assisting in company formation, doing market research, and giving data about international markets.
In simple words: Financial institutions help businesses by buying their shares, giving loans against assets, paying for technology services, offering guarantees to build trust, and providing other support like market research.

Exam Tip: Remember that financial institutions play a broad role, acting as both investors (buying shares) and lenders (providing loans and guarantees) to support business growth and operations.