Debentures, Loans, Retained Earnings and Short-Term Sources (ISC Class 12 Commerce)
Updated 18 October 2026 · Fact-checked
A debenture is a written acknowledgement of debt promising fixed interest and repayment on a fixed date; holders are creditors, unlike shareholders who are owners. Retained earnings are profits kept in the business. Banks and institutions give term loans. Short-term sources include cash credit, overdraft, bill discounting, public deposits, trade credit, customer advances, factoring, inter-corporate deposits and instalment credit.
Shareholders own the company and get a dividend only from profit; debenture holders are creditors who must be paid fixed interest always.
Illustration drawn for QuestionBuddy.
Understand Debentures, Loans, Retained Earnings and Short-Term Sources
1. Debentures. A written acknowledgement of a debt by a company promising interest at a fixed rate and repayment of principal on a fixed date. Holders are creditors.
*Kinds*: secured (mortgage) with a fixed or floating charge on assets, or unsecured (naked); redeemable or irredeemable; convertible into equity (fully or partly) or non-convertible; registered or bearer; first and second debentures (order of repayment).
*Advantages*: suit cautious investors; no dilution of control; interest is tax-deductible (cheaper than shares); trading on equity; funds for a fixed period. *Disadvantages*: fixed interest burden even in losses; charge on assets restricts further borrowing; risky when earnings fluctuate; must be redeemed.
2. Shares versus debentures
| Basis | Shares | Debentures |
|---|---|---|
| Holder | Owner | Creditor |
| Return | Dividend | Fixed interest |
| Voting rights | Yes (equity) | No |
| In losses | Dividend not compulsory | Interest compulsory |
| Security | Unsecured | Usually secured |
| Tax | Dividend not deductible | Interest deductible |
3. Retained earnings (ploughing back). Part of profit kept in the business.
*Merits*: no cost of issue and no interest; no dilution of control; increases financial strength and creditworthiness; meets expansion and contingencies; allows a stable dividend policy. *Demerits*: shareholders may be dissatisfied with lower dividends; uncertain source; may lead to misuse or idle funds; possible over-capitalisation; may encourage monopolistic concentration.
4. Loans from commercial banks and financial institutions. Term loans (medium and long term) for fixed assets and expansion, at a fixed or floating rate, usually secured and repaid in instalments. *Advantages*: quick and confidential; no dilution of control; interest tax-deductible; flexible terms; advice from institutions. *Disadvantages*: restrictive conditions (covenants), security required, fixed repayment burden, nominee directors in some cases.
5. Short-term sources
- Cash credit: borrowing up to a limit against stock or debts; interest on the amount used.
- Overdraft: drawing more than the balance in a current account up to a limit.
- Bill discounting and short-term loans from banks.
- Public deposits: accepted directly from the public, usually for 6 months to 3 years, at interest higher than banks; open only to reputed firms.
- Trade credit: suppliers allow payment later.
- Customer advances: customers pay part of the price in advance with the order.
- Factoring: selling receivables to a factor who advances cash and collects debts for a fee.
- Inter-corporate deposits (ICDs): unsecured short-term deposits by one company with another having surplus funds.
- Instalment credit: buying assets by a down payment and the balance with interest in instalments.
Debentures, Loans, Retained Earnings and Short-Term Sources: key facts
- Debenture holder
- Creditor
- Fixed interest
- No votes
- Usually secured
- Interest is tax-deductible.
- Retained earnings
- No issue cost
- No dilution
- Uncertain source
- Dissatisfaction risk
- Merits and demerits.
- Short-term sources
- Cash credit
- Overdraft
- Public deposits
- Trade credit
- Customer advances
- Factoring
- ICD
- Instalment credit
- Know one line each.
How to answer Debentures, Loans, Retained Earnings and Short-Term Sources questions
Questions ask for kinds, merits and demerits, distinctions, or the source in a situation.
- 1Match keywords: fixed interest and creditor point to debentures; selling receivables to factoring; surplus cash between companies to ICD.
- 2For distinctions, use at least four bases in a table.
- 3For merits and demerits, give points from the company's side, with reasons.
- 4In sums, compute interest, after-tax cost or instalments carefully.
Debentures, Loans, Retained Earnings and Short-Term Sources in real life
The idea, met in an everyday situation. Answer the question in your own words, then compare with the model answer. The one-line hook is what to remember.
Factoring
Suppose a garment exporter has Rs 8,00,000 of unpaid bills from customers and sells them to a factor who pays 80% at once and charges a 2% fee on the bill value.
Name the source and compute the cash received at once and the fee.
Try it first, then show the solutionSolution
- Selling receivables to get cash is factoring.
- Cash now = 80% of 8,00,000 = Rs 6,40,000; fee = 2% of 8,00,000 = Rs 16,000.
Answer: Factoring; Rs 6,40,000 cash now and Rs 16,000 fee.
Memory hook: Factor buys your bills.
Customer advances
Imagine a tailor asks for 40% of Rs 1,50,000 in advance for a bulk uniform order.
How much is raised, and which source is it?
Try it first, then show the solutionSolution
- Advance = 40% of 1,50,000 = Rs 60,000.
- Customers pay part of the price in advance.
Answer: Customer advances; Rs 60,000.
Memory hook: Customers fund the work.
Tricks to remember Debentures, Loans, Retained Earnings and Short-Term Sources
Short memory aids. Say each one aloud once, then use it on a question the same day.
Owner gets dividend, creditor gets interest
Shares: owner and dividend. Debentures: creditor and interest.
Use it when: Shares versus debentures.
Short-term eight: COPTCFII
C-O-P-T-C-F-I-I: Cash credit, Overdraft, Public deposits, Trade credit, Customer advances, Factoring, ICD, Instalment credit.
Use it when: Listing short-term sources.
Debentures, Loans, Retained Earnings and Short-Term Sources: solved examples
Ordered from board level to HOTS. Try each one before you open the solution.
Example 1: Identify the source · 1 mark · MCQBoard level
A company sells its trade receivables to a firm which pays cash immediately and collects the debts for a fee. This source is:
(a) factoring
(b) overdraft
(c) instalment credit
(d) retained earnings
Try it first, then show the solutionSolution
- Selling receivables to a factor is factoring.
Answer: (a)
Example 2: Merits of retained earnings · 4 marks · Short answerBoard level
State two merits and two demerits of retained earnings as a source of finance.
Try it first, then show the solutionSolution
- Merit 1: no cost of issue or interest.
- Merit 2: no dilution of control.
- Demerit 1: shareholders may be dissatisfied with lower dividends.
- Demerit 2: it is an uncertain source because it depends on profits.
Answer: Merits: no issue cost, no dilution. Demerits: dissatisfaction, uncertainty.
Example 3: After-tax cost of debentures · 4 marks · Short answerHarder board level
A company issues 9% debentures of Rs 5,00,000, and its tax rate is 30%. Calculate the annual interest, the tax saved, and the effective interest cost, and explain why debentures are cheaper than preference shares.
Try it first, then show the solutionSolution
- Interest = 9% of 5,00,000 = Rs 45,000.
- Tax saved = 30% of 45,000 = Rs 13,500.
- Effective cost = 45,000 - 13,500 = Rs 31,500, i.e. 6.3% of 5,00,000.
- Interest is tax-deductible, whereas preference dividend is not, so debentures cost less.
Answer: Interest Rs 45,000; tax saved Rs 13,500; effective cost Rs 31,500 (6.3%).
Example 4: Instalment credit · 4 marks · Short answerHarder board level
A company buys a machine priced at Rs 2,40,000 on instalment credit: Rs 60,000 down and 12 equal monthly instalments of Rs 16,500. Calculate the total paid and the interest cost, and state one advantage of this source.
Try it first, then show the solutionSolution
- Instalments = 12 x 16,500 = Rs 1,98,000.
- Total paid = 60,000 + 1,98,000 = Rs 2,58,000.
- Interest cost = 2,58,000 - 2,40,000 = Rs 18,000.
- Advantage: the machine is acquired immediately by paying only a part of the price.
Answer: Total Rs 2,58,000; interest Rs 18,000.
Example 5: Choose the short-term source · 8 marks · Long answerHOTS / competency
Suppose a company needs Rs 5,00,000 for six weeks to meet a seasonal stock build-up; it has Rs 3,00,000 of unpaid customer bills, a good bank relationship, and a supplier who is willing to wait. Suggest and evaluate four suitable sources, mentioning one drawback of each.
Try it first, then show the solutionSolution
- Cash credit or overdraft: flexible, interest only on the amount used; drawback: needs security and limits apply.
- Factoring of the Rs 3,00,000 bills: cash at once and collection by the factor; drawback: a fee is charged.
- Trade credit: the supplier allows payment later; drawback: may lose cash discounts or depend on the supplier.
- Bill discounting: bills converted to cash at a discount; drawback: the discount reduces proceeds.
- These suit a short need because they are short term; long-term debentures would be unsuitable for a six-week need.
Answer: Cash credit or overdraft, factoring, trade credit and bill discounting, each with a drawback.
Where students lose marks in Debentures, Loans, Retained Earnings and Short-Term Sources
The slips examiners see most often, and what to write instead.
Mistake: Calling debenture holders owners
They are creditors with no voting rights.
Wrong working
Debenture holders are owners of the company.
Right working
Debenture holders are creditors and receive fixed interest.
Do this: Owners get dividend; creditors get interest.
Usually costs: 1-2 marks.
Mistake: Mixing overdraft and cash credit
Cash credit is against stock or debts; overdraft is on a current account.
Wrong working
Overdraft is a loan against stock.
Right working
Overdraft allows withdrawing more than the balance of a current account up to a limit; cash credit is borrowing up to a limit against stock or debts.
Do this: Link each to its basis.
Usually costs: 1 mark.
Mistake: Forgetting the tax saving on interest
Interest is tax-deductible.
Wrong working
Effective cost = 45,000.
Right working
Effective cost = 45,000 - 13,500 = 31,500.
Do this: Deduct tax saved.
Usually costs: 1-2 marks.
Exam tips
- Keep a table for shares versus debentures with at least four bases.
- Public deposits run for roughly 6 months to 3 years as stated in the chapter; give the range, not one figure.
- Match each short-term source with its keyword.
- In sums, show interest, tax and net separately.
Practice questions on Debentures, Loans, Retained Earnings and Short-Term Sources
Write each answer on paper first. Open the hint only if you are stuck, and the answer only when you have finished.
Q1 · 1 mark · Very short answerBoard level
Who are debenture holders: owners or creditors?
Hint
Interest.
Answer
Creditors.
Q2 · 2 marks · Short answerBoard level
State two kinds of debentures.
Hint
Security and conversion.
Answer
Secured and unsecured; redeemable and irredeemable; convertible and non-convertible; registered and bearer (any two).
Q3 · 2 marks · Short answerHarder board level
What is an inter-corporate deposit, and why does it suit a company with surplus cash?
Hint
Between companies.
Answer
An unsecured short-term deposit made by one company with another. The company with surplus cash earns interest for a short period instead of leaving the cash idle, and the borrower gets funds quickly.
Q4 · 4 marks · Short answerHarder board level
Calculate the cash received now and the fee if a firm factors bills of Rs 6,00,000, receiving 75% in advance and paying a fee of 1.5% of the bills.
Hint
Two separate percentages.
Answer
Advance = 75% of 6,00,000 = Rs 4,50,000. Fee = 1.5% of 6,00,000 = Rs 9,000. Net cash now = 4,50,000 - 9,000 = Rs 4,41,000 if the fee is deducted at once.
Q5 · 4 marks · Short answerHOTS / competency
Suppose a company's earnings are very uncertain. Evaluate whether it should raise Rs 20,00,000 through 12% secured debentures or equity shares.
Hint
Fixed interest burden.
Answer
Debentures carry a fixed interest of 12% of Rs 20,00,000, which is Rs 2,40,000 a year, payable even in losses, and a charge on assets, so with uncertain earnings they are risky. Equity shares carry no fixed burden but dilute control and cost more. For uncertain earnings equity is safer, even though control is shared.
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.What does a debenture promise?Show answer
Fixed interest and repayment on a fixed date.
2.What is factoring?Show answer
Selling receivables to a factor for cash and collection.
3.Name one merit of retained earnings.Show answer
No dilution of control or no cost of issue.
4.What is customer advance?Show answer
Part of the price paid in advance with the order.
Debentures, Loans, Retained Earnings and Short-Term Sources: frequently asked questions
Are debentures always secured?
No. They may be secured or unsecured.
Why is interest on debentures cheaper than dividends?
Interest is tax-deductible, whereas dividend is not.
Can any company accept public deposits?
The chapter says they are available only to reputed firms.