Business Finance Part 2 notes!

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Dec 31, 2009
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Business Finance

* Business Finance

* Working Capital

* Islamic Finance

* Sources of Industrial Finance

Q.1. Discuss the principles of financing.


State the importance and sources of short-term finance.

Finance is required for business for the purpose of production and distribution of goods and services. No business, big or small can be run without finance. It is the life blood of business organizations. Money is needed to start the business. It is required to keep the business going and to expand the business. For production of goods and services we need material, machines, space, energy and technical know-how. For all these things we require finance. Finance is also needed for getting the goods from producer to consumer. The wholesaler and retailers need money for buying goods from different sources. Even consumer wants money to meet his requirements.

In modern large scale business with complex methods of production and distribution finance is used for various purposes. It is necessary for buying fixed assets such as, building, machinery, raw materials, labour and other expenses to convert the raw material into finished goods. It is also needed for meeting the other business operating expenses.

Finance may be defined as the provision of money at time it is needed. By business finance we mean finance needed by the business in different situations.

According to George Terry "Finance consists of providing and utilizing the money, capital rights, credit and funds of any kind which are employed in the operation of an enterprise." So business finance means investing borrowing and spending of money in proper manner for the operation of business. Importance of finance cannot be ignored for the success of business. No business can run smoothly without the finance. There is always a need of sufficient amount of capital to achieve the desired results from the business operation.

In olden days not much finance was needed owing to the limited and simple nature of production and distribution of goods. Today the modern business operation became more complex due to specialization, division of labour and mechanization to produce goods at large scale. Goods are now produced in anticipation of demand. This has increased the importance of finance in the modern business.

Principals of Financing

Generally, business finance is obtained by two means. Firstly, the owner of business himself introduces capital to form a business, Secondly, finance is obtained through borrowing from the people outside the organisation who provide finance on the basis of the principals of safety, profitability and liquidity. These principals are described below:

1. Principal of Profitability

An investor must employ funds in useful and profitable channels. He must think many times that money invested in a business should not become bad or uncollectable. He should not lend to a borrower with whom remuneration may be much, but also equally risky. On the other hand lender should prefer a borrower who is offering a higher rate of interest or profit on comparatively lesser risk.

2. Principal of Safety

The money which will be employed must be secured. Therefore, an investor must be very careful and ensure that his money is in safe hands where the risk of losses does not exist. He must ensure that the borrower is a person of character and will repay the money borrowed, including the profit or interest thereon. He must also see the capacity of borrower to repay the money borrowed. He must also consider whether amount invested for is reasonable in relation to the borrower's own investment.

3. Principle of Easy Recovery

An investor must consider the possibility of easy recovery of funds invested in a business. He always invest money where he is assured of the immediate recovery. Investment in company shares and loans from banks and financial institutions are the examples of investment on the basis of this principle.

Types of Finance

On the basis of the purpose for which capital is required, finance may be classified into long term finance and short term finance.

Long Term Finance

The long term finance refers to the amount required for acquiring fixed assets like machinery, land, building, furniture and equipments etc. These assets remain in use for a long period and to acquire these long term finance is needed which is sunk in the business permanently or for a long term and is not available for immediate conversion into cash.

The amount of long term capital required by a concern depends on the nature and size of the business. Long term finance is utilized for establishing a new business or for expanding an existing business and to replace the old fixed assets by new assets or to acquire the benefits of new inventions, methods and technologies. Long term capital is invested for ten or more years.
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Short Term Finance

It is required for day to day working of the business. It is required for the purchase of raw materials and for the payment of manufacturing, establishment, selling and distribution expenses. It is also required for holding convertible assets like stock of merchandise, receivables, and cash etc. In the course of business these assets are used again and again for the earning of profit. The finance required for this purpose is invested for a shorter period is known as short term finance or working capital. It represents the total investment in current assets such as cash, stock, receivables etc., minus current liabilities.

Medium Term Finance

Some economists give another classification if finance as "Medium Term Finance". According to them finance required for the duration range from one year to ten years may be termed as Medium Term Finance.

Sources of Long Term Finance

The Long Term Finance must be basically provided by the owners of the concern since it is the amount which is permanently sunk in the business. To acquire fixed assets of the business long term finance can be divided into two parts:

1. Corporate Financing

In a company, the long term finance is raised by issue of shares. Additional fixed capital required when the business expands, is raised by means of long-term borrowings, such as the issuance of debenture, floatation of mudarba, accepting public deposits, borrowing from bank and other financial institutions and ploughing back of profits.

2. Non-Corporate Financing

This financing refers to the sole proprietorship and partnership, etc. In sole proprietorship business, long term finance is provided by the sole trader himself. In and partners may also acquire long term loan from their friends and relatives.

Sources of Short Term Finance

Such finance is required for acquiring the current assets of business and meeting the operating expenses of business. A business concern must have sufficient funds to carry on its current operations. The sources from which short term finance or working capital is derived are of utmost importance. For short term business needs are financed either out of internal sources or external borrowings. The extent to which external sources can be relied upon depends on various factors such as stability of the profit of the concern, its goodwill and credit standing in the market, the amount of cash readily available at any time, etc. Following are the main sources of short term capital.

Internal Sources

The initial working capital or short term capital is financed by the proprietorship of the business concern. Emergency requirements must be financed from internal sources, i.e., by utilization of the reserve funds built up by the concern.

External Sources

1. Trade Credit

It is a common practice of business community that they allow credit facilities to each other on open account for shorter periods ranging from 10 days to 90 days. In accounting it terms "trade creditors" or "accounts receivables" indicate sellers and buyers respectively.

Trade credit help in maintaining the flow of business smoothly. The manufacturer buys raw materials and many services on credit terms and sells the finished goods to wholesalers on credit. The wholesaler sells the merchandise to retailers on open account and the retailers to the same for their customers i.e., the consumers.

2. Commercial Banks

Commercial Banks offer short-term loans and advances to business concern during busy seasons. Banks also provide credit facilities by discounting Bill of exchange and granting overdraft.

3. Commercial Credit House

The concerns allow short term loans or credit on the basis of pledge or martgage or property of needy business concerns.

4. Public Deposits

Sometimes companies arrange short term finance by inviting public to deposit their savings with them. They usually offer a rate of interest higher than the bank rate.

5. Private Loans

Generally to meet emergency requirements sole proprietors and partnerships obtain short term finance from their friends and relatives.

6. Financial Institutions

In certain situations financial corporations and development banks also provide short term credit or loans to industrial and commercial concerns Agricultural Development Bank, Industrial Development Bank, Small Industries Corporations are the examples of such financial institutions.

7. Loan by Partners

Partnership firms may obtain loans from their partners to meet the short term needs.

8. Loans from Directors

Some companies have provisions for obtaining loans from directors for short term financial requirements.

9. Government Loans

In some special situations government also provide short term loans to traders. In some cases only certain types of small business concerns, unable to secure the needed loans through private channels are provided financial help by the government.


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Q.2. What do you mean by working capital. State its importance in business?

Adequacy of working capital rises the credit standing of the concern. Such a concern can buy goods on better terms and reduce the cost of production on account of receipt of cash discounts.
A concern is sure to fail, if there is no adequate supply of materials or cash. Nowadays production is carried on in anticipation of demand. There is a time between the point of supply of raw material and the ultimate realization of the sale proceeds of finished products. A large amount of working capital is required to keep the business moving continuously. Many new businesses are floated very well in the beginning but are unable to run properly usually because of inadequacy of working capital.

Kinds of Working Capital

Working capital a short term finance is of two types:
1. Initial Working Capital
It is the amount required to meet all current expenses the early development of business. This period may vary in different types of business according to their nature.

2. Regular Working Capital
It is the amount required after the business has been established as a going concern. The regular capital consists of two parts
(a) Fixed
(b) Variable

(a). Fixed Working Capital is the minimum amount of working capital required to carry on normal business operations. Every business has to maintain a minimum inventory of raw materials work in process, finished goods, etc. It always requires short term finance for making certain regular payments such as purchases, salaries, wages and rent etc.

(b). Variable Working Capital part of working capital is also known as seasonal or special working capital. It is the additional amount required during busy seasons on emergencies or under certain abnormal conditions such as in cases of rising prices, strikes and lock-out etc.

Factors Governing Short-Term Or Working Capital

1. Nature of Business
It is an important feature of determining the amount of working capital. Trading concerns requires large amount of working capital since their investment in current assets such as bills and book debts, etc., is more than that in fixed assets. Manufacturing units engaged in producing producer's goods require lesser proportion of working capital. Public utilities like transport, electricity corporations, etc., need relatively little amount of working capital.

2. Size of Business
Small size business needs relatively large amount of working capital than a larger business.

3. Conversion of Working Capital
The speed with which working capital changes its form also affects the amount of working capital needed. If cash is converted into inventory into bills and books debts and bills into cash within a short time, the business can be managed with a small amount of working capital.

4. Turnover
Where there is a rapid turnover, it is possible to carry on business with comparatively limited amount of working capital.

5. Terms of Trade
A concern which makes purchases in on credit and sells for cash only, requires a smaller amount of working capital.

6. Cash Flow
When inflow of cash is greater than its outflow, a smaller amount of working capital is required.

7. Seasonal Variations
If the demand and/or supply are seasonal and widely fluctuate, more working capital is needed.

8. Absence of Coordination
The absence of coordination in the policies of production and distribution of goods may result in higher demand for working capital.

9. Transport Facilities
If means of transport facilities and communication available are not adequate and satisfactory the business concern is faced to maintain a large amount of stock of goods. This needs higher amount of working capital.


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Q.3. Define Modaraba. Discuss the various types of Modaraba.


Define Musharika. Discuss the various types of Musharika.


What do you mean by Qarz-e-Hasana? Discuss in the light of Holy Quran and Hadith.


Islam, being a complete religion, has prohibited "riba" or "interest", in all forms and manifestations in the absence of any blueprint or a workable model of interest free economic system, utmost care with collected gradualness will have to be exercised to bring about a smooth switchover without disrupting the process of capital formation.

Basically, the task of Islamising the financial system revolves around, institutional arrangements, which, on the other hand, reconcile the freedom of the individual with the optimum use of total resources and on the other, do not conflict with the Islamic tenets of equity and fairness. It appears that financial system is based on principles of profit and loss sharing may meet these requirements. While this may cleanse the financial system from the evil of "riba". Its total elimination will be possible only when the savers earn their income out of "halal" activity and the entrepreneurs do not cross the limits of "halal" business and "halal" profits. Again, an Islamic system would be as much in need of optimum capital formation as any other economic system, be it capitalist or socialist or mixed economy.

As an Islamic state, Pakistan has embarked on the task of building a socio-economic order based on the principles of equity and justice enshrined in the Islamic concept of "Al-Adl-Wal-Ahsan". A beginning in this direction has been made by introducing Zakat and Ushr in the personal level and eliminating interest from financial transactions at the institutional level.


Modaraba is a form of contract a subscriber (Rabulmal) participates with his money and the manager (Modarib) with his efforts and skills, after setting aside the agreed share of Modarib the profits earned on investments are distributed among the subscribers.

In simple words Modaraba means a business in which a subscriber participates with his money and the manager, as "Modarib" participates with his efforts and skills and profits on investment made out of the Modaraba Funds are distributed among the subscribers. Thus, it is a concept of Islamic finance through which one partner or more participate with funds and another with his skill and efforts in some trade, business and industry permitted by Islam. They are who participates with his efforts assumes the role of manager, while the provider of funds becomes the beneficial owner. In modern terminology, a "modaraba" is akin to the concept of mutual finds minus its unIslamic features. The concept of mutual fund has gained widespread acceptance in the country as is evidenced by the success of N.I.T units and I.C.P Mutual Funds.

Characteristics of Modaraba

1. Under Modaraba Capital of one is combined with the labour of the other to earn something.

2. Both Muslim and non-Muslim can carry business under Modaraba.

3. A special contract is executed for a particular business under Modaraba.

4. A contract for Modaraba may also be verbal.

5. Islam has provided more safety and security to the invested capital in Modaraba as compared to the modern partnership business.

6. Distribution of profit is decided mutually by the subscriber (Rab-ul-Mal) and the manager (Mubarib) that what would be the principle for distributing the profit between themselves.

Types of Modaraba

Modaraba can be broadly classified into two types:

1. Multiple Modaraba

A Modaraba having more than one specific purpose or objective. A company for instance, may float a multipurpose modaraba e.g., for finding a transport service, operating an automobile factory or workship and providing services as packers.

2. Specific Purpose Modaraba

A Modaraba for a specific purpose such as getting up cement plant or building and selling houses, or commercial buildings or industrial structures etc.

For the purpose of regulating the floating and operations of modaraba, a law known as Modaraba Companies and Modaraba (Floatation and Control) Ordinance, 1980, has already been promulgated by the Federal Government.


The word "Musharika" is derived from Arabic word "Shirakat" which means sharing or working together., enjoying equitable participatory and managerial rights and sharing all liabilities and accountability in the equitable proportions. It is a conscious cooperation between two or more persons arising out of free consent and in mutual interest to achieve pre-determined and mutually agreed goals towards which they must work collectively, contribute to collective effort in equitable proportions and share the results success or disaster, in proportions commensurate with their respective contributions to collective efforts, which may comprise of investment of capital, human efforts and skills in varying proportions.

Kinds of Musharika

There are following kinds of Musharika (Shirakat)

1. Shirakat Wajuh

A shirakat under which two or more persons be associated as partners, even without token participation in investment of capital and human effort, with a view to enhancing the public image of the enterprise because of their high standing in the market and/or in society, which could help the enterprise in completing preconditions for rapid take-off and in achieving vigorous expansion in sales.

2. Shirakatul Ainan

Under this all partners contribute to collective efforts in mutually agreed proportions and share the liabilities and accountability for operating results in proportions to their respective contributions. This is also the most common and most feasible form of partnership.


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3. Shirakatul Abadan

Under this two or more persons may work towards achieving predetermined and mutually agreed business goals by pooling in their physical and/or mutual labour but without pooling in capital investment. It is obvious that such form of shirakat is feasible only for such business operations whose capital intensity is nil or virtually zero. It is also known shirakatul sinnaia. Under this share of profit may be equal or unequal as agreed among the shariks.

4. Shirakatul Mufawaza

It is a partnership entrancing all monetary resources of the parties to the contract. In equal numbers and involving mutual agency and surety ship on the part of the partners. All partners are jointly and severely liable for the debts of the firm and each partner acts as the agent of the firm, which is also the spirit of the existing Partnership Act. In the contract of shirakatul Mufawaizat only Muslim can participate with other Muslim shariks only and not otherwise.

5. Shirakatul Mazural

It is share cropping, under which land belonging to one person is tilled by another and the produce is shared.

6. Shirakatul Milk

It is the kind of co-ownership due to joint possession of property acquired through inheritance.

Musharika in Banking

Musharika provide working capital funds for industrial and commercial enterprise. Working capital funds are invested in trade, agriculture, purchase of raw material, etc. In case of "Musharika" relationship between banks and customer is of participants and not of creditor and debtor.


Whenever, a man needs money for consumptional purposes, which he hopes to be able to repay at some future time, Islam enjoins that the money should be provided by his more fortunate, neighbour, friends or acquaintances without any interest leaving the debtor to return the money at his convenience. This type of credit is called the worthy credit "qarz-e-hasana" in Islamic terminology.

Qarz-e-hasana has been described in Holy Quran:

If the debtor is suffering from poverty, he must be relaxed to pay Sadaqah or charity, it is very much desirable by Allah.

As mentioned above, Qarz-e-hasana is not given for a specified period, therefore, it is not demanded by the creditor to refund, instead, the debtor is allowed to return the money as he becomes capable of doing this. Holy Quran warns the debtor that as soon as he becomes capable to return the loan, he must refund it to the creditor otherwise he will commit a great sin.

In accordance with a Hadith of Prophet Muhammad (PBUH):

Despite the acquisition of capability of capability to pay Qarz-e-Hasana delaying the payment of the right or receipt is a great sin.

Islam appreciates extension of Qarz-e-hasana and it is declared as ''Loan to Allah" because Allah is the only authority to reward this goodness and the reward given by Allah is the biggest of all rewards given in this world.


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Q.4. What are the various sources of industrial finances?


Write a short notes on Price Mechanism.
Sources of Industrial Finance

Industrial Finance may be required for short period or for long period. It may be raised by investment of proprietors as ownership funds or by borrowings. The various sources of finance may be broadly classified as under:

1. Ownership Funds

It includes owner's investment as sole proprietor or partners of a firm. In companies it is raised by issue of shares, ploughing back of profits, depreciation policy, dividend policy, reorganization and price mechanism.

2. Borrowed Funds

There are external sources of business. It includes borrowings from relatives and other sources by sole owners and partners of business. In companies borrowed funds include debentures public deposits, banks, insurance companies and special financial institutions.

Ownership Funds


The share capital of a company is dividend into small units called shares. A person who buys a share is called the shareholder or member of the company.

The share capital forms a part of proprietary or ownership funds and used for financing the long-term requirements, the fixed capital and the fixed part of the regular working capital. It need not be repaid during the time of the company.

2. Ploughing Back of Profits

Like all individuals, companies also save a portion of their profits to be used to meet future needs. When the profits earned by a company, instead of being fully distributed to shareholders in the form of dividends, a portion is retained in the business as additional capital, it is known as ploughing back of profits.

Advantages of Ploughing Back Policy

(i). It improves the financial position of the company and frees it from the clutches of other financers.

(ii). This policy of self-financing enables the company to increase the profits by replacing its equipments. It can thus maintain a stable value of dividends in spite of the transfer of a portion of profits to reserve.

(iii). It also helps the company to earn more profits and pass on the benefits to the shareholders who can sell the shares at a premium.

Disadvantages of Ploughing Back Policy

The policy of ploughing back of profits must be implemented with cases. Otherwise, the company has to face the disadvantages of this policy.

(i). This may result in over capitalization, if the directors are over-zealous.

(ii). If the rate of divident is reduced due to this policy, the shareholders get disappointed.

(iii). The retained profits may not be used for the benefits for the company and diverted to some other companies.

(iv). The directors may manipulate the value of shares in the stock exchange. The declaration of low rate of dividend result in the fell of values of shares. The directors may buy the shares by taking advantage of low prices. Later, they may increase the rate of dividend and dispose of the shares in the market, when the prices rise.

3. Depreciation Policy

Depreciation is permanent decrease in the value of an asset through wear and tear in use or passage of time. It represents permanent fall in the market value of the asset. A good management policy, provides for adequate depreciation on its assets. Adequate depreciation charge is made with a view to recover through current earnings the original investment in the assets.

4. Dividend Policy

A good company always provides for all its liabilities before paying dividend to its shareholders. It is a part of a sound financial policy that company must try to establish a stable dividend rate. Frequent charges in the rates are likely to affect the values of shares on the stock exchange and effects the reputation of company in due course. For maintaining a stable dividend rate, the management is justified if does not pay dividends during the first few years in the case of new company which requires funds for development and financial stability.

The dividend may be paid in cash or by issue of bonus shares according to the availability of liquid assets and the extent of under capitalization existing in the company.

5. Reorganization

Reorganization of a company is done when it is in financial difficulties or when it is desired to like advantage of certain favourable conditions in the market. Reorganization may be internal or external.

Internal Reorganization: In internal reorganization the share capital is reorganized. A portion of capital is also cancelled to wipe out the capital losses.

External Reorganization: It takes place when a company goes into liquidation and a new company is formed with the value of assets and liabilities suitable adjusted.

6. Price Mechanism

The selling prices of the product is so fixed as to include a small fractional sum to sover the cost of future expansion. The additional sum so collected while realizing the sale proceeds of the product, is allowed to accumulate and is set aside for meeting the additional capital requirements. Under this method, the product becomes costly. This policy can be successfully employed only by a concern or which has monopoly in the matter of production and sale. If this policy is carried to its extremes and permanently to earn maximum profits, the concern may loose even in existing market.