Unit I

Introduction
We all know that every business requires some amount of money to start and
run the business. Whether it is a small business or large, manufacturing or
trading or transportation business, money is an essential requirement for
every activity. Money required for any activity is known as finance. So the
term business finance refers to the money required for business purposes
and the ways by which it is raised. Thus, it involves procurement and
utilisation of funds so that business firms will be able to carry out their
operations effectively and efficiently.
You know that a business unit cannot move a single step without sufficient
amount of finance. But before discussing the importance of finance, let us
learn in detail as to why does the business need funds.
Every business needs funds mainly for the following purposes:
1. To purchase fixed assets : Every type of business needs some fixed assets
like land and building, furniture, machinery etc. A large amount of money is
required for purchase of these assets.
2. To meet day-to-day expenses : After establishment of a business, funds
are needed to carry out day-to-day operations e.g., purchase of raw
materials, payment of rent and taxes, telephone and electricity bills, wages
and salaries, etc.
3. To fund business growth : Growth of business may include expansion of
existing line of business as well as adding new lines. To finance such growth,
one needs more funds.
4. To bridge the time gap between production and sales : The amount spent
on production is realised only when sales are made. Normally, there is a time
gap between production and sales and also between sales and realisation of
cash. Hence, during this interval, expenses continue to be incurred, for which
funds are required.
5. To meet contingencies : Funds are always required to meet the ups and
downs of business and for some unforeseen problems. Suppose, a
manufacturer anticipates shortage of raw materials after a period, then he
would like to stock the raw materials in large quantity. But he will be able to
do so only if sufficient money is available with him.
6. To avail of business opportunities : Funds are also required to avail of
business opportunities. Suppose a company wants to submit a tender for
which some amount of money is required to be deposited along with the
application. In case of non-availability of funds it would not be possible for
the company to submit the tender. Take another example. When a stockist
offers special discount on large amount of purchase of any particular
material then a manufacturer can avail of such offer, only if he has adequate
funds to buy it.

Business Finance : Meaning, Need and Importance

Business finance refers to money and credit employed in business. It
involves procurement and utilization of funds so that business firms may be
able to carry out their operations effectively and efficiently. The following
characteristics of business finance will make its meaning more clear:(i)

Business finance includes all types of funds used in business.

(ii)

Business finance is needed in all types of organisations large or small,

manufacturing or trading.

(iii)

The amount of business finance differs from one business firm to

another depending upon its nature and size. It also varies from time to time.

(iv)

Business finance involves estimation of funds. It is concerned with

raising funds from different sources as well as investment of funds for
different purposes.
Objectives & Scope
Business finance is required for the establishment of every business
organisation. With the growth in activities, financial needs also grow. Funds
are required for the purchase of land and building, machinery and other fixed
assets. Besides this, money is also needed to meet day-to-day expenses e.g.
purchase of raw material, payment of wages and salaries, electricity bills,
telephone bills etc. You are aware that production continues in anticipation of
demand. Expenses continue to be incurred until the goods are sold and
money is recovered. Money is required to bridge the time gap between
production and sales. Besides producers, may be necessary to change the
office set up in order to install computers. Renovation of facilities can be
taken up only when adequate funds are available.
Every business needs funds mainly for the following purposes:
1.To purchase fixed assets : Every type of business needs some fixed assets
like land and building, furniture, machinery etc. A large amount of money is
required for purchase of these assets.
2.To meet day-to-day expenses : After establishment of a business, funds are
needed to carry out day-to-day operations e.g., purchase of raw materials,

payment of rent and taxes, telephone and electricity bills, wages and
salaries, etc.
3.To fund business growth : Growth of business may include expansion of
existing line of business as well as adding new lines. To finance such growth,
one needs more funds.
4.To bridge the time gap between production and sales : The amount spent
on production is realised only when sales are made. Normally, there is a time
gap between production and sales and also between sales and realisation of
cash. Hence, during this interval, expenses continue to be incurred, for which
funds are required.
5.To meet contingencies : Funds are always required to meet the ups and
downs of business and for some unforeseen problems. Suppose, a
manufacturer anticipates shortage of raw materials after a period, then he
would like to stock the raw materials in large quantity. But he will be able to
do so only if sufficient money is available with him.
6.To avail of business opportunities : Funds are also required to avail of
business opportunities. Suppose a company wants to submit a tender for
which some amount of money is required to be deposited along with the
application. In case of non-availability of funds it would not be possible for
the company to submit the tender.
Take another example. When a stockist offers special discount on large
amount of purchase of any particular material then a manufacturer can avail
of such offer, only if he has adequate funds to buy it.
Recent Reforms in Financial Sector
Financial sector is the mainstay of any economy and it contributes
immensely in the mobilisation and distribution of resources. Financial sector
reforms have long been viewed as significant part of the program for policy
reform in developing nations. Earlier, it was thought that they were expected
to increase the efficiency of resource mobilization and allocation in the real
economy to generate higher rates of growth. Recently, they are also seen to
be critical for macroeconomic stability. It was due to the repercussion of the
East Asian crisis, since weaknesses in the financial sector are broadly
regarded as one of the major causes of collapse in that region.
The elements of the financial sector are Banks, Financial Institutions,
Instruments and markets which mobilise the resources from the surplus
sector and channelize the same to the different needy sectors in the
economy. The process of accumulative capital growth through
institutionalisation of savings and investment fosters economic growth.
Reform of the financial sector was recognized, from the very beginning, as an
integral part of the economic reforms initiated in 1991. The economic reform
process occurred amidst two serious crisis involving the financial sector the
balance of payments crisis that endangered the international credibility of

the country and pushed it to the edge of default; and the grave threat of
insolvency confronting the banking system which had for years concealed its
problems with the help of faulty accounting strategies. Furthermore, some
deep rooted problems of the Indian economy in the early nineties were also
strongly related to the financial sector such as large scale pre-emption of
resources from the banking system by the government to finance its fiscal
deficit. Excessive structural and micro regulation that inhibited financial
innovation and increased transaction costs. Relatively inadequate level of
prudential regulation in the financial sector. Poorly developed debt and
money markets. And outdated (often primitive) technological and
institutional structures that made the capital markets and the rest of the
financial system highly inefficient (Mathieu, 1998).
Major aims of the financial sector reforms are to allocate the resources
proficiently, increasing the return on investment and hastened growth of the
real sectors in the economy. The processes introduced by the Government of
India under the reform process are intended to upturn the operational
efficiency of each of the constituent of the financial sector.
The major delineations of the financial sector reforms in India were found as
under:

Removal of the erstwhile existing financial repression.

Creation of an efficient, productive and profitable financial sector.

Enabling the process of price discovery by the market determination of

interest rates that improves allocate efficiency of resources.

Providing operational and functional autonomy to institutions.

Preparing the financial system for increasing international competition.

Opening the external sector in a calibrated manner.

Promoting financial stability in the wake of domestic and external

shocks.

At global level, financial sector reforms have been driven by two apparently
contrary forces. The first is a thrust towards liberalization, which seeks to
decrease, if not eliminate a number of direct controls over banks and other
financial market participants. The second is a thrust in favour of strict
regulation of the financial sector. This dual approach is also apparent in the
reforms tried in India.

Financial and banking

Financial markets

sector

Regulators

The banking system

Non-banking finance companies

The capital market

Mutual funds

Overall approach to reforms

Deregulation of banking system

Capital market developments

Consolidation imperative

reforms

are

in

following

areas:

Regulators
The Finance Ministry constantly formulated major strategies in the field of
financial sector of the country. The Government acknowledged the important
role of regulators. The Reserve Bank of India (RBI) has become more
independent. Securities and Exchange Board of India (SEBI) and the
Insurance Regulatory and Development Authority (IRDA) became important
institutions. Some opinions are also there that there should be a superregulator for the financial services sector instead of multiplicity of regulators.
Indian Banking Sector and Financial Reforms
The main intent of banking sector reforms was to uphold a diversified,
efficient and competitive financial system with the aim of improving the
allocative efficiency of resources through operational flexibility, improved
financial viability and institutional solidification.
As early as August 1991, the government selected a high level Committee on
the Financial System (the Narasimham Committee) to look into all facets of
the financial system and make comprehensive recommendations for
improvements. The Committee submitted its report in November 1991,
making several recommendations for reforms in the banking sector and also
in the capital market. Soon thereafter, the government announced broad
acceptance of the approach of the Narasimham Committee and a process of

gradualist reform in the banking sector and in the capital market was set in
motion, a process that has now been under way for more than six year.

In India, around 80% of businesses are regulated by public sector banks.

PSBs are still governing the commercial banking system. The RBI has given
licenses to new private sector banks as part of the liberalization process. The
RBI has also been granting licenses to industrial houses. Many banks are
effectively running in the retail and consumer segments but are yet to
deliver services to industrial finance, retail trade, small business and
agricultural finance. Major change observed by individuals is many
transformation in policies of the banking sector. The reforms have focussed
on eliminating financial repression through reductions in statutory preemptions, while stepping up prudential regulations at the same time.
Additionally, interest rates on both deposits and lending of banks have been
gradually deregulated.
The major reforms relating to the banking system were:

Capital base of the banks were strengthened by recapitalization, public

equity issues and subordinated debt.

Prudential norms were introduced and progressively tightened for

income recognition, classification of assets, provisioning of bad debts,
marking to market of investments.

Pre-emption of bank resources by the government was reduced

sharply.

New private sector banks were licensed and branch licensing

restrictions were relaxed.

Similarly, several operational reforms were introduced in the area of

credit policy:

Detailed regulations relating to Maximum Permissible Bank Finance

were abolished.

Consortium regulations were relaxed substantially.

Credit delivery was shifted away from cash credit to loan method.

Many reports signified that the initial steps have been taken in the form of
allowing new banks to set up shop. Private Corporates, public sector entities
and Non-Banking Finance Companies with a strong track record can now
apply to set up new banks and the Reserve bank of India will consider these
applications in the coming months. The addition of new banks will mean
more competition for this sector in the country and it will lead to a
development in services for the end customer. It is anticipated to increase
financial enclosure as more and more people across the country will be able
to access banking facilities. In reforms for the existing banks the public
sector banks have been allowed to increase or decrease the authorised
capital without the presence of an overall ceiling. This will provide greater
flexibility to the banks to conduct their fund raising activities as per the
requirements. The strict restriction of voting rights in banks will also be
relaxed and this will aid the banking sector to develop, as large investors will
be able to get a bigger voice in the coming days in the banks and the
manner in which they operate.
When evaluating banking sector reform, it can be identified that banks have
experienced strong balance sheet growth in the post-reform period in an
environment of operational flexibility. Enhancement in the financial health of
banks, reflected in noteworthy improvement in capital adequacy and
improved asset quality, is distinctly observable. It is striking that this
progress has been realised despite the espousal of international best
practices in prudential norms. Competitiveness and productivity gains have
also been enabled by proactive technological deepening and flexible human
resource management. These significant gains have been achieved even
while renewing goals of social banking viz. maintaining the wide reach of the
banking system and directing credit towards important but underprivileged
sectors of civilisation.
Foreign Exchange Market Reform
Forex market reform took place in 1993 and the successive adoption of
current account convertibility were the acmes of the forex reforms
introduced in the Indian market. Under these reforms, authorised dealers of
foreign exchange as well as banks have been given greater sovereignty to
perform in activities and numerous operations. Additionally, the entry of new
companies have been allowed in the market. The capital account has
become effectively adaptable for non-residents but still has some
reservations for residents.
Impact on the Reform Measures
The broader objectives of the financial sector reform process are to articulate
the policy to enhance the financial condition and to reinforce the institutions.
As part of the reforms process, many private banks were granted licence to

operate in India. This has resulted into a competitive environment in the

banking industry which in turn has assisted in using the resources more
competently. Conventionally, the industrial units were sanctioned term loan
by the development banks and working capital by the commercial banks.
The reform process has transformed the pattern of financing and now both
the institutions are willing to extend long term loan as well as working capital
loan. But there is some difference in the mode of operation. This has
empowered the industrial units to avail credit facilities from a single
institution. Despite the fact that the banks provide both the term loan and
the working capital loans, the industrial units prefer the development banks
for the following reasons.
It provides equal support to the new as well as existing industries.
The
period
of
repayment
of
loan
is
comparatively
longer.
Besides providing financial backing, it acts as the implementing agency for
the different government sponsored schemes. Hence the industrial units can
avail of both the financial assistance as well as the incentives offered under
various development schemes through a Single Window System. As lending
is the main activity of these institutions, it acquires specialisation in this field
and can share its expertise with the industrial units.
Reform of the Insurance Sector
The Insurance sector in India directed by Insurance Act, 1938, the Life
Insurance Corporation Act, 1956 and General Insurance Business
(Nationalisation) Act, 1972, Insurance Regulatory and Development Authority
(IRDA) Act, 1999 and other related Acts. The basis of liberalizing the banking
system and encouraging competition among the three major participants'
viz. public sector banks, Indian private sector banks, and foreign banks,
applies equally to insurance. There is a strong case for ending the public
sector monopoly in insurance and opening it up to private sector participants
subject to suitable prudential regulation.
Cross-country data advocates that contractual savings institutions are highly
significant determinant of the aggregate rate of savings and insurance and
pension schemes are the most important form of contractual savings in this
reference. A competitive insurance industry providing diversified insurance
products to fulfil differing customer needs, can help increase savings in this
situation and allocate them efficiently. The insurance and pensions industry
has long-term liabilities which it seeks to match by investing in long-term
secure assets. A healthy insurance is an important source of long-term
capital in domestic currency which is especially for infrastructure financing.
Improvements in insurance will strengthen the capital market at the longterm end by adding new companies in this section of the market, giving it
greater depth or liquidity. Reforms in insurance are likely to create a flow of

finance for the corporate sector if people can simultaneously make progress
in reducing financial deficit.
The Malhotra Committee had suggested opening up the insurance sector
to new private companies as early as 1994. It took five years to build an
agreement on this issue and legislation to open up insurance, allowing
foreign equity up to 26 per cent was finally submitted to Parliament in 1999.
Overall Approach to Reforms
It is assessed that since last many years, there have seen major
improvements in the working of various financial market contributors. The
government and the regulatory authorities have followed a step-by-step
approach. The entry of foreign companies has helped in the start of
international practices and systems. Technology developments have
enhanced customer service. Some gaps however remain such as lack of an
inter-bank interest rate benchmark, an active corporate debt market and a
developed derivatives market. In general, the cumulative effect of the
developments since 1991 has been quite encouraging. An indication of the
strength of the reformed Indian financial system can be seen from the way
India was not affected by the Southeast Asian crisis.
To summarize, the financial sector is main element of the Indian economic
system. Financial experts suggested that there is a need for effective reforms
to ensure that this remains competitive and attractive for investors from
across the world. The economic reforms have preferred the need for
changing the policy objective to promotion of industries and the formation of
more integrated infrastructural facilities. Financial sector reforms are centre
point of the economic liberalization that was introduced in India in mid-1991.
It was witnessed that national financial liberalisation has brought about the
deregulation of interest rates, dismantling of directed credit, improving the
banking system, enhancing the functioning of the capital market that include
the government securities market. Regulators and economic experts put
more emphasis on banking reforms to enhance economy and enable people
to access numerous facilities. Fundamental objective of financial sector
reforms in the 1990s was to create an effectual, competitive and steady that
could contribute in greater measure to inspire progression.

Sources of Business Finance

The type and amount of funds required usually differs from one business to
another. For instance, if the size of business is large, the amount of funds
required will also be large. Likewise, the financial requirements are more in
manufacturing business as compared to trading business. The business

needs funds for longer period to be invested in fixed assets like land and
building, machinery etc. Sometimes, the business also needs funds to be
invested for shorter period. So based on the period for which the funds are
required, the business finance is classified into three categories.
(a) Short-term Finance;
(b) Medium-term Finance; and
(c) Long-term Finance;
Short term Finance
Funds required to meet day-to-day expenses are known as short-term
finance. This is required for purchase of raw materials, payment of wages,
rent, insurance, electricity and water bills, etc. The short-term finance is
required for a period of one year or less. This financial requirement for short
period is also known as working capital requirement or circulating capital
requirement. It may be noted that a part of the working capital requirement
is of a long-term nature, as certain minimum amount of funds are always
kept to meet the requirement of stock and regular day-to-day expenses.
Medium-term Finance
Medium-term finance is utilised for all such purposes where investments are
required for more than one year but less than five years. Amount required to
fund modernization and renovation, special promotional programmes etc. fall
in this category.
Long-term Finance
The amount of funds required by a business for more than five years is called
long-term finance. Generally this type of finance is required for the purchase
of fixed assets like land and building, plant and machinery, furniture etc. The
long-term finance is also known as fixed capital as such need in fact is, of a
permanent nature.

Capital Market
Capital market is defined as a financial market that works as a channel for
demand and supply of debt and equity capital. It channels the money
provided by savers and depository institutions (banks, credit unions,
insurance companies, etc.) to borrowers and investees through a variety of
financial instruments (bonds, notes, shares) called securities. A capital
market is not a compact unit, but a highly decentralized system made up of
three major parts that include stock market, bond market, and money
market. It also works as an exchange for trading existing claims on capital in
the form of shares. The Capital Market deals in the long-term capital
Securities such as Equity or Debt offered by the private business companies
and also governmental undertakings of India.
Structure of Capital Market of India
In the agenda of financial sector reforms, Improvement of the capital market
is important area and action has been taken parallel with reforms in banking.
India has experienced functioning in capital markets the Bombay Stock
Exchange (BSE) for over a hundred years but until the 1980s, the volume of
activity in the capital market was relatively limited. Capital market activity
extended rapidly in the 1980s and the market capitalization of companies
registered in the BSE rose from 5 per cent of GDP in 1980 to 13 per cent in
1990. It is observed that the Indian capital market has perceived major
reforms in the decade of 1990s and thereafter. It is on the edge of the
growth. Thus, the Government of India and SEBI took numerous measures in
order to improve the working of the Indian stock exchanges and to make it
more progressive and energetic. The Securities and Exchange Board of India
(SEBI) was well-known in 1988. It got a legal status in 1992. SEBI was
principally set up to control the activities of the commercial banks, to control
the operations of mutual funds, to work as a promoter of the stock exchange
activities and to act as a regulatory authority of new issue activities of
companies. The SEBI was established with the vital objective, "to protect the
interest of investors in securities market and for matters connected
therewith or incidental thereto." The main functions of SEBI are as follows:

To control the business of the stock market and other securities

market.

To promote and regulate the self-regulatory organizations.

To forbid fraudulent and unfair trade practices in securities market.

To promote awareness among investors and training of intermediaries

about safety of market.

To prohibit insider trading in securities market.

To regulate huge acquisition of shares and takeover of companies.

However the stock market remained primeval and poorly controlled.

Companies who want to access the capital market needed prior permission
of the government which also had to approve the price at which new equity
could be raised. While new issues were strictly controlled, there was
insufficient regulation of stock market activity and also of various market
participants including stock exchanges, brokers, mutual funds, etc. The
domestic-capital market was also closed to portfolio investment from abroad
except through a few closed ended mutual funds floated abroad by the Unit
Trust of India (UTI) which were committed to Indian investment.
The practice of reform of the capital market was started in 1992 along the
lines recommended by the Narasimham Committee. It was intended to
remove direct government control and replacing it by a regulatory framework
based on transparency and disclosure supervised by an independent
regulator. The first step was taken in 1992 when the Securities and Exchange
Board of India (SEBI), which was initially established as a non-statutory body
in 1988, was raised to a complete capital market regulator with statutory
powers in 1992. The requirement of prior government permission for
accessing capital markets and for prior approval of issue pricing was stopped
and companies were permissible to access markets and price issues freely,
subject only to disclosure norms laid down by SEBI.
Opening the Capital Market to Foreign Investors
Significant policy initiative in 1993 was the opening of the capital market to
foreign institutional investors (FIIs) and allowing Indian companies to raise
capital abroad by issue of equity in the form of global depository receipts
(GDRs).
Modernization of Trading and Settlement Systems
Major developments occurred in trading methods which were highly
antiquated earlier. The National Stock Exchange (NSE) was established in
1994 as an automated electronic exchange. It empowered brokers in 220
cities all over the country to link up with the NSE computers via VSATs and
trade in a unified exchange with automatic matching of buy and sell orders
with price time priority, thus ensuring maximum transparency for investors.

The initiation of electronic trading by the NSE generated competitive

pressure which forced the BSE to also introduce electronic trading in 1995.
Futures Trading
Currently, an important gap in India's capital market is future markets. Good
market in index futures would help in risk management and provide greater
liquidity to the market. A decision to present futures trading has been taken
and the legislative changes needed to implement this decision have been
submitted to parliament.

Primary Market (New Issue Market)

Primary market is also known as new issue market. As in this market
securities are sold for the first time, i.e., new securities are issued from the
company. Primary capital market directly contributes in capital formation
because in primary market company goes directly to investors and utilises
these funds for investment in buildings, plants, machinery etc.
The primary market does not include finance in the form of loan from
financial institutions because when loan is issued from financial institution it
implies converting private capital into public capital and this process of
converting private capital into public capital is called going public. The
common securities issued in primary market are equity shares, debentures,
bonds, preference shares and other innovative securities.
Method of Floatation of Securities in Primary Market
The securities may be issued in primary market by the following methods:

1. Public Issue through Prospectus

Under this method company issues a prospectus to inform and attract
general public. In prospectus company provides details about the purpose for
which funds are being raised, past financial performance of the company,
background and future prospects of company.
The information in the prospectus helps the public to know about the risk
and earning potential of the company and accordingly they decide whether
to invest or not in that company Through IPO company can approach large
number of persons and can approach public at large. Sometimes companies
involve intermediaries such as bankers, brokers and underwriters to raise
capital from general public.

2. Offer for Sale

Under this method new securities are offered to general public but not
directly by the company but by an intermediary who buys whole lot of
securities from the company. Generally the intermediaries are the firms of

brokers. So sale of securities takes place in two steps: first when the
company issues securities to the intermediary at face value and second
when intermediaries issue securities to general public at higher price to earn
profit. Under this method company is saved from the formalities and
complexities of issuing securities directly to public.

3. Private Placement
Under this method the securities are sold by the company to an intermediary
at a fixed price and in second step intermediaries sell these securities not to
general public but to selected clients at higher price. The issuing company
issues prospectus to give details about its objectives, future prospects so
that reputed clients prefer to buy the security from intermediary. Under this
method the intermediaries issue securities to selected clients such as UTI,
LIC, General Insurance, etc.
The private placement method is a cost saving method as company is saved
from the expenses of underwriter fees, manager fees, agents commission,
listing of companys name in stock exchange etc. Small and new companies
prefer private placement as they cannot afford to raise from public issue.
4. Right Issue (For Existing Companies)
This is the issue of new shares to existing shareholders. It is called right issue
because it is the pre-emptive right of shareholders that company must offer
them the new issue before subscribing to outsiders. Each shareholder has
the right to subscribe to the new shares in the proportion of shares he

already holds. A right issue is mandatory for companies under Companies

Act 1956.
The stock exchange does not allow the existing companies to go for new
issue without giving pre-emptive rights to existing shareholders because if
new issue is directly issued to new subscribers then the existing equity
shareholders may lose their share in capital and control of company i.e., it
would water their equity. To stop this the pre-emptive or right issue is
compulsory for existing company.

5. e-IPOs, (electronic Initial Public Offer)

It is the new method of issuing securities through on line system of stock
exchange. In this company has to appoint registered brokers for the purpose
of accepting applications and placing orders. The company issuing security
has to apply for listing of its securities on any exchange other than the

exchange it has offered its securities earlier. The manager coordinates the
activities through various intermediaries connected with the issue.
Secondary Market (Stock Exchange):
The secondary market is the market for the sale and purchase of previously
issued or second hand securities.
In secondary market securities are not directly issued by the company to
investors. The securities are sold by existing investors to other investors.
Sometimes the investor is in need of cash and another investor wants to buy
the shares of the company as he could not get directly from company. Then
both the investors can meet in secondary market and exchange securities for
cash through intermediary called broker.
In secondary market companies get no additional capital as securities are
bought and sold between investors only so directly there is no capital
formation but secondary market indirectly contributes in capital formation by
providing liquidity to securities of the company.
If there is no secondary market then investors could get back their
investment only after redemption period is over or when company gets
dissolved which means investment will be blocked for a long period of time
but with the presence of secondary market, the investors can convert their
securities into cash whenever they want and it also gives chance to investors
to make profit as securities are bought and sold at market price which is
generally more than the original price of the securities.
This liquidity offered by secondary market encourages even those investors
to invest in securities who want to invest for small period of time as there is
option of selling securities at their convenience.