In case of proprietorship business, the individual proprietor generally invests his own savings to start with, and may borrow money on his personal security or the security of his assets from others. Similarly, the capital of a partnership firm consists partly of funds contributed by the partners and partly of borrowed funds. But the company from of organization enables the promoters to raise necessary funds from the public who may contribute capital and become members (share holders) of the company. In course of its business, the company can raise loans directly from banks and financial institutions or by issue of securities (debentures) to the public. Besides, profits earned may also be reinvested instead of being distributed as dividend to the shareholders.
Thus for any business enterprise, there are two sources of finance, viz, funds contributed by owners and funds available from loans and credits. In other words the financial resources of a business may be own funds and borrowed funds.
1. Owner Funds or Ownership Capital
The ownership capital is also known as ‘risk capital’ because every business runs the risk of loss or low profits, and it is the owner who bears this risk. In the event of low profits they do not have adequate return on their investment. If losses continue the owners may be unable to recover even their original investment. However, in times of prosperity and in the case of a flourishing business the high level of profits earned accrues entirely to the owners of the business. Thus, after paying interest on loans at a fixed rate, the owners may enjoy a much higher rate of return on their investment. Owners contribute risk capital also in the hope that the value of the firm will appreciate as a result of higher earnings and growth in the size of the firm.
The second characteristic of this source of finance is that ownership capital remains permanently invested in the business. It is not refundable like loans or borrowed capital. Hence a large part of it is generally used for a acquiring long–lived fixed assets and to finance a part of the working capital which is permanently required to hold a minimum level of stock of raw materials, a minimum amount of cash, etc.
Another characteristic of ownership capital related to the management of business. It is on the basis of their contribution to equity capital that owners can exercise their right of control over the management of the firm. Managers cannot ignore the owners in the conduct of business affairs. The sole proprietor directly controls his own business. In a partnership firm, the active partner will take part in the management of business. A company is managed by directors who are elected by the members (shareholders).
Arising out of its characteristics, the advantages of ownership capital may be briefly stated as follows:
- It provides risk capital
- It is a source of permanent capital
- It is the basis on which owners acquire their right of control over management
- It does not require security of assets to be offered to raise ownership capital
There are also certain limitations of ownership capital as a source of finance. These are:
- The amount of capital, which may be raised as owners fund depends on the number of persons, prepared to take the risks involved. In a partnership confer, a few persons cannot provide ownership capital beyond a certain limit and this limitation is more so in case of proprietary form of organization.
- A joint stock company can raise large amount by issuing shares to the public. Bus it leads to an increased number of people having ownership interest and right of control over management. This may reduce the original investors’ power of control over management. Being a permanent source of capital, ownership funds are not refundable as long as the company is in existence, even when the funds remain idle.
- A company may find it difficult to raise additional ownership capital unless it has high profit-earning capacity or growth prospects. Issue of additional shares is also subject to so many legal and procedural restrictions.
2. Borrowed Funds and Borrowed Capital
It includes all funds available by way of loans or credit. Business firms raise loans for specified periods at fixed rates of interest. Thus borrowed funds may serve the purpose of long-term, medium-term or short-term finance. The borrowing is generally at against the security of assets from banks and financial institutions. A company to borrow the funds can also issue various types of debentures.
Interest on such borrowed funds is payable at half yearly or yearly but the principal amount is being repaid only at the end of the period of loan. These interest and principal payments have to be met even if the earnings are low or there is loss. Lenders and creditors do not have any right of control over the management of the borrowing firm. But they can sue the firm in a law court if there is default in payment, interest or principal back.
From the business point of view, borrowed capital has several merits.
- It does not affect the owner’s control over management.
- Interest is treated as an expense, so it can be charged against income and amount of tax payable thereby reduced.
- The amount of borrowing and its timing can be adjusted according to convenience and needs, and
- It involves a fixed rate of interest to be paid even when profits are very high, thus owners may enjoy a much higher rate of return on investment then the lenders.
There are certain limitations, too in case of borrowed capacity.
- Payment of interest and repayment of loans cannot be avoided even if there is a loss. Default in meeting these obligations may create problems for the business and result in decline of its credit worthiness. Continuing default may even lead to insolvency of firm.
- Secondly, it requires adequate security to be offered against loans. Moreover, high rates of interest may be charged if the firm’s ability to repay the loan in uncertain.