Borrowed Funds MCQs Quiz | Class 10

Understanding Borrowed Funds in Business Finance

Borrowed funds are external sources of finance that a business acquires with an obligation to repay the principal amount along with interest within a specified period. They are a critical component of a company’s capital structure, enabling expansion, working capital management, and asset acquisition without diluting ownership.

Key Sources of Borrowed Funds:

• Loans: Funds obtained from financial institutions (banks, non-banking financial companies) for various purposes like long-term investment or short-term working capital.
• Debentures: Long-term debt instruments issued by companies to raise capital from the public. Debenture holders are creditors, not owners.
• Credit: A broad term referring to the ability to obtain goods or services before payment, based on trust. Examples include trade credit and bank credit.
• Public Deposits: Unsecured deposits invited by companies directly from the public.
• Commercial Paper: Short-term unsecured promissory notes issued by highly rated companies.

1. Loans

Loans are a fundamental source of finance for businesses. They come with a fixed repayment schedule and an agreed interest rate. Loans can be broadly categorized based on their tenure and purpose:

• Term Loans: These are usually long-term or medium-term loans provided for financing fixed assets like land, building, machinery, or for business expansion projects. They often require collateral.
• Working Capital Loans: These are short-term loans designed to meet the day-to-day operational needs of a business, such as purchasing raw materials, paying wages, or managing inventory. Examples include cash credit and bank overdrafts.

Features of Loans: Interest obligation, collateral requirements (for secured loans), fixed repayment schedule, and often covenants (conditions) imposed by the lender.

2. Debentures

Debentures are debt instruments that acknowledge a loan taken by the company. They are typically long-term sources of finance and are a popular choice for large corporations.

• Interest: Debenture holders receive a fixed rate of interest, which is a charge against the profits of the company.
• No Voting Rights: Unlike shareholders, debenture holders do not have any ownership rights or voting rights in the company’s management.
• Repayment: Debentures are redeemed (repaid) after a specific period, or at maturity.

Types of Debentures:

• Secured Debentures: Backed by specific assets of the company, offering security to debenture holders.
• Unsecured Debentures: Not backed by any specific asset, relying on the company’s creditworthiness.
• Redeemable Debentures: Repaid by the company at the end of a fixed period or in installments during the lifetime of the company.
• Irredeemable Debentures (Perpetual Debentures): Not repayable during the lifetime of the company, but are repayable only on the happening of a contingency or winding up of the company.
• Convertible Debentures: Can be converted into equity shares of the company after a certain period, at the option of the debenture holder.
• Non-convertible Debentures: Cannot be converted into equity shares.

3. Credit

Credit facilitates business operations by allowing companies to acquire resources immediately and pay later. Two significant forms are:

• Trade Credit: This is credit extended by one business to another for the purchase of goods and services. For example, a supplier allowing a business to pay for raw materials after 30 or 60 days. It is a common source of short-term finance.
• Bank Credit: Refers to various facilities provided by banks, such as overdrafts, cash credit, discounting of bills of exchange, which help businesses manage their working capital needs.

Quick Revision Points:

• Borrowed funds carry an obligation to repay principal and interest.
• Loans provide capital from banks/financial institutions, often secured by collateral.
• Debentures are long-term debt instruments issued by companies, offering fixed interest.
• Trade credit is short-term finance from suppliers for goods/services.
• A key advantage of borrowed funds is no dilution of ownership; a disadvantage is fixed repayment obligation.

Practice Questions:

1. What is the primary difference between a shareholder and a debenture holder in terms of company ownership?
2. Explain the concept of ‘trade credit’ and its significance for small businesses.
3. When might a company prefer issuing debentures over taking a long-term bank loan?
4. List two advantages and two disadvantages of using borrowed funds for business expansion.
5. Distinguish between secured and unsecured debentures.