Sources of Business Finance Class 11: Owners' Funds and Borrowed Funds Explained

What Sources of Business Finance is about

Weightage: This chapter is part of Unit 7, Sources of Business Finance. The syllabus groups Unit 7 with Unit 8, Small Business: together they carry 20 of the 80 theory marks in the school annual exam.Source: CBSE Business Studies (054) syllabus 2026-27, Class XI course structure, Unit 7 Sources of Business Finance

Key concepts

Meaning, nature and significance of business finance

NCERT section 8.2

Business finance refers to the funds and credit used in a business. Finance is the lifeblood of business: without it, no activity is possible.

Needs:

• Fixed capital requirements: to buy fixed assets (land, buildings, machinery, furniture). Large in manufacturing; small in trading.
• Working capital requirements: to meet day-to-day expenses (raw materials, wages, rent, stock, credit to customers).
• Modernisation, expansion and diversification: to adopt new technology, grow and enter new lines.

The amount needed depends on the nature and size of the business: a steel plant needs huge fixed capital; a retail shop needs relatively more working capital.

Worked example

Classify: (a) money to buy a delivery van; (b) money to pay this month's salaries; (c) money to stock up for the festive season.

Try it first, then show the solutionSolution

1. (a) Fixed asset: fixed capital
2. (b) Day-to-day expense: working capital
3. (c) Inventory: working capital

Answer: (a) Fixed capital; (b) and (c) working capital.

Classification of sources of funds

NCERT section 8.3

On the basis of period:

• Long-term (more than 5 years): equity shares, preference shares, retained earnings, debentures, loans from financial institutions. For fixed capital.
• Medium-term (1 to 5 years): loans from banks and financial institutions, public deposits.
• Short-term (up to 1 year): trade credit, loans from banks (cash credit, overdraft), inter-corporate deposits. For working capital.

On the basis of ownership:

• Owners' funds: provided by owners (equity, preference capital, retained earnings). A permanent source; no fixed obligation to repay during the company's life; owners get control (equity).
• Borrowed funds: loans (debentures, bank loans, public deposits, trade credit, ICDs). Repayable after a fixed period with fixed interest, a charge on profit payable even in loss; usually secured on assets; lenders do not get control.

On the basis of source of generation:

• Internal sources: generated within the business: retained earnings, collection of receivables, disposal of surplus stock.
• External sources: raised from outside: shares, debentures, loans, public deposits, trade credit.

Worked example

Classify retained earnings by all three bases.

Try it first, then show the solutionSolution

1. Period: long-term (permanent)
2. Ownership: owners' funds (belongs to shareholders)
3. Generation: internal source

Answer: Long-term, owners' fund, internal source.

Equity shares

NCERT section 8.4

Equity shares represent the ownership capital of a company. Equity shareholders are the real owners: they have voting rights and control management through the board. They get dividends only after preference dividend is paid, and the dividend is not fixed; on winding up they are paid last (residual claim). Equity capital is permanent: not refunded during the company's life.

Merits:
1. Suitable for investors willing to take risk for higher returns.
2. No burden of fixed dividend: dividend is paid only if there are profits.
3. Permanent capital: no repayment except on winding up.
4. Provides credit-worthiness: equity is a cushion for lenders.
5. Funds can be raised without creating a charge on assets.
6. Democratic control: voting rights to shareholders.

Limitations:
1. Investors who want steady income may not prefer them.
2. Cost of equity is higher than debt (higher expected returns; dividend not tax-deductible).
3. Issue of more equity can dilute control of existing shareholders.
4. More formalities and delays in issue.
5. Over-capitalisation may result if too much equity is raised.

Worked example

Why are equity shareholders called "residual claimants"?

Try it first, then show the solutionSolution

1. They are paid dividend after preference shareholders
2. On winding up they get capital back only after creditors and preference shareholders

Answer: Because they receive whatever is left after all other claims are met.

Preference shares

NCERT section 8.4

Preference shares carry two preferential rights over equity shares: (i) dividend at a fixed rate before any equity dividend, and (ii) return of capital before equity shareholders on winding up. They usually have no voting rights (except on matters directly affecting their rights).

Types:

• Cumulative / non-cumulative: unpaid dividends of a loss year accumulate and are paid later / do not accumulate.
• Participating / non-participating: share in surplus profits after equity dividend / do not.
• Convertible / non-convertible: can be converted into equity after a period / cannot.
• Redeemable / irredeemable: repaid after a fixed period / not repaid during the company's life (irredeemable preference shares cannot be issued under the Companies Act, 2013).

Merits: steady income for cautious investors; no dilution of control (no voting); fixed dividend allows trading on equity (equity holders may gain); no charge on assets; useful for raising long-term funds without diluting control.

Limitations: not suitable for investors who want ownership and growth; dividend not tax-deductible, so costlier than debentures; preference dividend is a priority claim on profits, reducing what is left for equity; rate of dividend is generally higher than debenture interest.

Worked example

Suppose a company could not pay preference dividend last year and earns profits this year. If its preference shares are cumulative, what must it do before paying equity dividend?

Try it first, then show the solutionSolution

1. Cumulative shares accumulate unpaid dividends
2. Arrears and this year's preference dividend must be paid first

Answer: Pay both last year's arrears and this year's preference dividend before any equity dividend.

Retained earnings

NCERT section 8.4

Retained earnings (ploughing back of profit) are the part of net profit kept in the business instead of being paid out as dividends. It is an internal source of long-term owners' funds; the shareholders' wealth is reinvested.

Merits: permanent source; no explicit cost (no interest, dividend or flotation cost); no dilution of control; increases credit-worthiness; absorbs unexpected losses; may raise the market price of shares.

Limitations: uncertain: depends on profits, which fluctuate; shareholders may be dissatisfied with low dividends; has an opportunity cost that management may ignore, leading to sub-optimal use of funds.

Worked example

Suppose a company earns a profit of ₹50 lakh and pays ₹20 lakh as dividend. How much is retained and what kind of source is it?

Try it first, then show the solutionSolution

1. Retained = 50 − 20 = ₹30 lakh
2. It is an internal, long-term owners' fund

Answer: ₹30 lakh of retained earnings: an internal owners' fund.

Debentures and bonds

NCERT section 8.4

A debenture is an instrument acknowledging a debt of the company; debenture holders are creditors who receive fixed interest at regular intervals, whether or not there is a profit, and are repaid after a fixed period. Bonds are similar debt instruments (the term is used especially for public sector and government borrowings).

Types:

• Secured / unsecured: backed by a charge on assets / not backed.
• Registered / bearer: holders' names recorded with the company, transfer by registration / transferable by delivery.
• Convertible / non-convertible: can be converted into equity / cannot.
• First / second: repaid before / after others on winding up.

Merits: preferred by investors who want fixed income at lower risk; no dilution of control (no voting rights); interest is tax-deductible, so cheaper than equity; useful when sales and earnings are stable; allows trading on equity.

Limitations: fixed obligation: interest must be paid even in loss, which is risky when earnings fluctuate; creates a charge on assets, limiting future borrowing; repayment burden on maturity; increases financial risk and may lower credit-worthiness.

Trading on equity: using fixed-cost funds (debentures) to raise returns to equity shareholders when the return on investment is higher than the interest rate.

Particulars	Plan A: all equity	Plan B: 50% equity, 50% 10% debentures
EBIT (₹)	2,00,000	2,00,000
Less: interest (₹)	0	50,000
Profit before tax (₹)	2,00,000	1,50,000
Less: tax @ 30% (₹)	60,000	45,000
Profit after tax (₹)	1,40,000	1,05,000
Number of equity shares	1,00,000	50,000
EPS (₹)	1.40	2.10

With EBIT of ₹2,00,000 (a 20% return on ₹10 lakh, above the 10% interest), Plan B gives higher EPS. But if EBIT falls to ₹40,000, EPS becomes ₹0.28 under Plan A and −₹0.14 under Plan B: the fixed interest burden makes debt risky in bad years.

Worked example

Why can a company with steady, high profits benefit from issuing debentures instead of equity?

Try it first, then show the solutionSolution

1. Interest is fixed and tax-deductible
2. If earnings on the funds exceed the interest rate, the surplus goes to equity shareholders (trading on equity)
3. Control is not diluted

Answer: It raises EPS through trading on equity at a lower cost without diluting control.

Loans from banks and financial institutions, public deposits, trade credit and ICDs

NCERT section 8.4

Loans from commercial banks: for short and medium periods (cash credit, overdraft, term loans), usually against security. Merits: timely funds; secrecy (no public disclosure); easy compared with share issues; flexible (can be repaid when funds are not needed). Limitations: usually short or medium term; detailed investigation and security needed; restrictive terms may limit the firm.

Loans from financial institutions (specialised institutions set up by central and state governments, such as industrial development banks): long and medium-term finance and advice, often when banks and markets are not willing. Merits: long-term funds; financial, managerial and technical advice; increases goodwill (careful scrutiny); funds even in depression. Limitations: rigid criteria and many formalities; restrictions on dividends; may nominate directors to the board.

Public deposits: deposits raised directly from the public by companies, usually for 1-3 years, at interest higher than bank deposits (subject to RBI and Companies Act rules). Merits: simple procedure; cost may be lower than bank loans; no charge on assets; no dilution of control. Limitations: difficult for new companies; unreliable for large amounts; collection may be hard if the public is not interested.

Trade credit: credit extended by suppliers (buy now, pay later), shown as creditors and bills payable. Merits: convenient and continuous; available without formalities; no charge on assets; helps increase stock when sales are expected to rise. Limitations: easy credit may cause over-trading; only limited funds; generally costlier if cash discounts are lost.

Inter-corporate deposits (ICDs): unsecured short-term deposits made by one company with another, usually for up to a year (call deposits, three-month and six-month deposits). Merits: quick, with few formalities; useful for short-term needs. Limitations: unsecured, so risky for the lender; interest rates vary with the market; regulations limit the amounts.

Worked example

Suppose a company has a 3-month cash shortage before festival sales, and another group company has idle funds. Which source suits it best?

Try it first, then show the solutionSolution

1. Short-term need; quick funds with few formalities
2. An inter-corporate deposit from the cash-rich company fits

Answer: An inter-corporate deposit (or a short-term bank loan/cash credit).

Sources of Business Finance in real life

Each concept, met in an everyday situation. Read the situation, answer the question in your own words, then compare with the model answer. The one-line hook is what to remember.

Topics in this chapter

• Borrowed Funds: Debentures, Trading on Equity, Loans, Public Deposits, Trade Credit and ICDs (CBSE 11)
• Classification of Funds and Owners' Funds: Equity Shares, Preference Shares and Retained Earnings (CBSE 11)

Sources of Business Finance: key facts

Classification

Period (long, medium, short); Ownership (owners', borrowed); Generation (internal, external)

Owners' funds

Equity shares + Preference shares + Retained earnings

Permanent; no fixed repayment.

Borrowed funds

Debentures/bonds, Loans from banks and financial institutions, Public deposits, Trade credit, ICDs

Fixed interest; repayable.

Preference share types

Cumulative/non-, Participating/non-, Convertible/non-, Redeemable

Two preferences: dividend and capital.

Debenture types

Secured/unsecured, Registered/bearer, Convertible/non-, First/second

EPS

EPS = (EBIT − Interest)(1 − tax rate) ÷ Number of equity shares

Used to show trading on equity.

Retained earnings

Retained earnings = Net profit − Dividend

Internal source.

How the school exam asks Sources of Business Finance

The question patterns to expect, and the method that works for each.

Tricks to remember Sources of Business Finance

Short memory aids. Say each one aloud once, then use it on a question the same day.

• Classification: "POG"

  Period, Ownership, Generation.

  Use it when: Bases of classification.

• Owners' funds: "EPR"

  Equity, Preference, Retained earnings.

  Use it when: Owners' funds.

• Borrowed funds: "Do Banks Pay Traders Interest?"

  Debentures, Banks and FIs, Public deposits, Trade credit, ICDs.

  Use it when: Borrowed funds.

Sources of Business Finance: exam-level solved questions

Ordered from exam level to HOTS. Cover the solution, write your own, then compare step by step.

Case-study practice (Section E style)

Read the situation, then answer every part. In a school exam set on the board pattern this is a 4-mark question split into 1 + 1 + 2 marks.

Where the marks are

How a typical answer is split into step marks. Show every step: a right final answer alone rarely earns full marks.

Where students lose marks in Sources of Business Finance

The slips examiners see most often, and what to write instead.

• ✗Mistake: Calling debenture holders owners

  They invest in the company like shareholders.

  ✓Do this: Debenture holders are creditors who receive fixed interest; shareholders are owners.

  Usually costs: 1 mark.

• ✗Mistake: Saying preference shareholders have full voting rights

  They are shareholders.

  ✓Do this: They usually vote only on matters affecting their own rights.

  Usually costs: 1 mark.

• ✗Mistake: Treating retained earnings as cost-free in every sense

  No interest is paid.

  ✓Do this: Mention the opportunity cost and possible shareholder dissatisfaction.

  Usually costs: 1 mark in evaluation questions.

• ✗Mistake: Writing about ADRs, GDRs and bill discounting

  Older syllabus topics.

  ✓Do this: These were dropped in the rationalisation; stick to the listed sources.

  Usually costs: Time lost.

NCERT exercise guide: Sources of Business Finance

What each exercise in the NCERT chapter tests, how to approach it, and a question of the same kind solved step by step. Questions here are written in our own words.

Practice questions on Sources of Business Finance

Write each answer on paper first. Open the hint only if you are stuck, and the answer only when you have finished.

1. Q1 · 1 mark · MCQExam level

   Equity shareholders are:
   (a) creditors
   (b) owners
   (c) lenders
   (d) suppliers

   Hint

   Ownership capital.

   Answer

   (b) owners

2. Q2 · 1 mark · MCQExam level

   Inter-corporate deposits are generally:
   (a) long-term and secured
   (b) short-term and unsecured
   (c) owners' funds
   (d) issued to the public

   Hint

   Company to company.

   Answer

   (b) short-term and unsecured

3. Q3 · 1 mark · Very short answerExam level

   What is meant by working capital?

   Hint

   Day to day.

   Answer

   Funds needed for day-to-day operations: raw materials, wages, stock, receivables.

4. Q4 · 3 marks · Short answerExam level

   Give three merits of equity shares.

   Hint

   No fixed burden.

   Answer

   No fixed dividend burden; permanent capital; improves credit-worthiness (also no charge on assets, democratic control).

5. Q5 · 3 marks · Short answerHarder exam level

   Explain three limitations of debentures as a source of finance.

   Hint

   Fixed obligation.

   Answer

   Fixed interest must be paid even in loss; creates a charge on assets, limiting further borrowing; repayment burden on maturity (also higher financial risk).

6. Q6 · 3 marks · Short answerHarder exam level

   Classify by period: equity shares, trade credit, public deposits, debentures, cash credit.

   Hint

   Long, medium, short.

   Answer

   Long: equity shares, debentures. Medium: public deposits. Short: trade credit, cash credit.

7. Q7 · 4 marks · Long answerHarder exam level

   Explain the merits and limitations of public deposits.

   Hint

   Simple vs unreliable.

   Answer

   Merits: simple procedure; may be cheaper than bank loans; no charge on assets; no dilution of control. Limitations: hard for new companies; unreliable for large amounts; collection difficult if public interest is low.

8. Q8 · 4 marks · Long answerHarder exam level

   Explain how loans from financial institutions help companies, with two limitations.

   Hint

   Long-term plus advice.

   Answer

   They provide long-term funds when banks and markets may not; offer managerial and technical advice; improve goodwill; available even in depression. Limitations: rigid criteria and formalities; restrictions such as limits on dividends or nominee directors.

9. Q9 · 4 marks · Short answerHarder exam level

   Distinguish between shares and debentures on four bases.

   Hint

   Owner vs creditor.

   Answer

   Status: owners vs creditors. Return: dividend (variable for equity) vs fixed interest. Voting: yes (equity) vs no. Security and priority: unsecured, paid last vs usually secured, paid before shareholders.

10. Q10 · 3 marks · Short answerHarder exam level

    What is trading on equity? When does it benefit shareholders?

    Hint

    Return > interest.

    Answer

    Using fixed-cost funds (debt, preference capital) to increase returns to equity shareholders. It benefits them when the return earned on total capital exceeds the cost of the fixed-cost funds.

11. Q11 · 4 marks · Long answerHarder exam level

    Explain retained earnings with two merits and two limitations.

    Hint

    Internal, no explicit cost.

    Answer

    Profits kept in the business instead of being distributed. Merits: permanent and no explicit cost; no dilution of control (also credit-worthiness, absorbs losses). Limitations: uncertain because profits fluctuate; shareholders may be dissatisfied (also opportunity cost ignored).

12. Q12 · 4 marks · Long answerHOTS / competency

    Suppose a new start-up with no profit history needs ₹2 crore. Which of these sources are realistic for it and which are not: public deposits, equity from investors, trade credit, debentures, retained earnings? Explain.

    Hint

    Track record matters.

    Answer

    Realistic: equity from investors (willing to take risk for growth); some trade credit from suppliers. Hard: public deposits (the public trusts established firms), debentures (lenders want security and steady earnings to pay fixed interest), retained earnings (no profits yet). Bank loans may be possible with security.

Test your recall

Answer in your head or on paper first, then open the card. Pulling an answer out of memory makes it stick far better than re-reading.

1. 1.What are the two preferences of preference shares?Show answer

   Fixed dividend before equity and return of capital before equity on winding up.

2. 2.Is interest on debentures tax-deductible?Show answer

   Yes.

3. 3.Give an internal source of finance.Show answer

   Retained earnings.

4. 4.What is an ICD?Show answer

   An inter-corporate deposit: an unsecured short-term deposit by one company with another.

5. 5.What is fixed capital?Show answer

   Funds for buying fixed assets like land, buildings and machinery.

6. 6.Which shareholders have voting rights?Show answer

   Equity shareholders.

Quick revision checklist

The night before the exam: can you do each of these without looking?

• ☐Can you distinguish fixed and working capital?
• ☐Can you classify ten sources by period, ownership and generation?
• ☐Can you list merits and limitations of equity shares?
• ☐Can you explain four types of preference shares?
• ☐Can you explain why retained earnings are not truly free?
• ☐Can you list types, merits and limitations of debentures?
• ☐Can you show trading on equity with EPS figures?
• ☐Can you explain trade credit, public deposits and ICDs?

Sources of Business Finance: frequently asked questions