A Guide to Methods of Raising Finance for Businesses

Starting a new business or expanding an existing one always brings up one crucial question: Where will the money come from? Whether you’re planning to open a small retail shop in your neighborhood or dreaming of building the next big e-commerce platform, understanding how businesses raise capital is fundamental. Think of raising finance as fueling your business journey-different vehicles need different types of fuel, and businesses are no different. Let’s explore the various methods companies use to gather the resources they need to grow and thrive.

Understanding long-term financing through shares 🔗

When a company needs permanent capital that doesn’t have to be repaid, issuing shares becomes an attractive option. Shares represent ownership in a company, making shareholders part-owners rather than creditors. There are two main types of shares that companies use to raise funds.

Equity shares: ownership with voting power 🔗

Equity shares, also called ordinary shares, are the most common way companies raise permanent capital. When you buy equity shares, you’re not just investing money-you’re becoming a co-owner of the business. Equity shareholders enjoy voting rights, allowing them to participate in major company decisions like electing the board of directors or approving mergers.

The returns on equity shares come in two forms: dividends and capital appreciation. Imagine you bought shares of a promising startup at ₹100 each. If the company performs well, you might receive dividends from its profits, and your shares could be worth ₹150 or more in a few years. However, equity shareholders also bear the highest risk-if the company fails, they’re the last ones to receive anything after creditors and preference shareholders are paid.

Preference shares: priority with fixed returns 🔗

Preference shares offer a middle ground between equity shares and debt. These shares provide fixed dividends and preferential treatment during profit distribution and asset liquidation. Think of preference shareholders as VIP customers-they get served before ordinary shareholders, but they typically don’t get voting rights in company decisions.

For instance, if a company issues 8% preference shares with a face value of ₹100, shareholders receive ₹8 per share annually before equity shareholders get anything. This predictable income makes preference shares attractive to conservative investors who prefer stability over high-risk, high-reward scenarios.

Raising capital with debentures 🔗

Unlike shares that represent ownership, debentures are debt instruments where companies borrow money from investors with a promise to repay with interest. Think of debentures as formal IOUs with specific terms.

When companies issue debentures, they commit to paying a fixed interest rate regardless of whether they make profits or losses. For example, a company might issue 10-year debentures at 9% annual interest. If you invest ₹1 lakh, you’ll receive ₹9,000 every year for ten years, and get your ₹1 lakh back at maturity.

This arrangement benefits companies through what’s called “trading on equity.” If a company borrows at 9% but earns 15% returns on projects funded by debentures, the extra 6% profit goes entirely to equity shareholders. However, the fixed interest obligation can become burdensome during difficult times-interest must be paid even when the company isn’t making money.

Types of debentures for different needs 🔗

Debentures come in several varieties to suit different investor preferences. Secured debentures are backed by company assets, providing an extra safety cushion. Convertible debentures offer the flexibility to transform into equity shares after a certain period, appealing to investors who want debt security initially but equity participation later. Meanwhile, non-convertible debentures remain pure debt instruments throughout their tenure.

Loans from financial institutions and banks 🔗

Financial institutions and commercial banks serve as major sources of long and medium-term loans for businesses. These loans typically fund specific projects like factory modernization, purchasing machinery, or expanding production capacity.

What makes institutional loans attractive is their structured approach. Banks conduct thorough due diligence, assessing your business plan, cash flow projections, and repayment capacity. They usually require collateral-company assets that secure the loan. In India, institutions like SIDBI (Small Industries Development Bank of India) and various state financial corporations specialize in providing such loans to businesses at competitive rates.

Consider a retail chain planning to open five new stores. The company could approach a bank for a term loan covering 70% of the project cost, offering its existing property as collateral. The bank would disburse funds in stages as construction progresses, and the company would repay through fixed monthly installments over several years.

Utilizing public deposits and retained profits 🔗

Public deposits: borrowing directly from people 🔗

Public deposits allow companies to borrow money directly from individuals for a fixed period, typically ranging from six months to seven years. Companies historically used this method extensively, particularly for meeting short and medium-term fund requirements.

These deposits work like fixed deposits in banks-companies offer attractive interest rates to depositors and repay the principal amount at maturity. For businesses, this method provides funds without diluting ownership or creating complicated legal obligations. However, companies must maintain strong creditworthiness and transparency to attract public deposits.

Retained profits: self-financing through savings 🔗

Retained earnings, also called ploughing back of profits, represent one of the most economical sources of business finance. Instead of distributing all profits as dividends, companies retain a portion for reinvestment into the business.

Imagine a profitable company earning ₹50 lakh annually. Rather than paying out everything to shareholders, it might distribute ₹30 lakh as dividends and retain ₹20 lakh. Over five years, this creates a ₹1 crore reserve that can fund expansion without borrowing or issuing new shares.

This method offers several advantages: no interest payments, no obligation to repay, and no dilution of existing shareholders’ control. The company maintains financial flexibility and builds reserves that act as cushions during difficult times. However, excessive retention might disappoint shareholders expecting higher dividends.

Short-term finance options for immediate needs 🔗

Businesses constantly need funds for day-to-day operations-paying suppliers, managing inventory, and covering payroll. Short-term financing options address these immediate requirements without the complexity of long-term arrangements.

Trade credit: buying now, paying later 🔗

Trade credit is perhaps the simplest form of short-term financing. When suppliers allow you to purchase goods today and pay after 30, 60, or 90 days, they’re essentially providing interest-free credit. It’s like when your local kirana store lets regular customers settle their monthly account at month-end.

This arrangement helps businesses manage cash flow gaps. A clothing retailer might buy inventory worth ₹5 lakh on 60-day credit, sell the goods within 45 days, and use the proceeds to pay the supplier-all without using their own capital.

Factoring: converting receivables into immediate cash 🔗

Factoring involves selling your accounts receivable to a financial institution at a discount to receive immediate cash. When businesses sell goods on credit, money gets locked in unpaid invoices. Factoring unlocks this capital.

Here’s how it works: Suppose your company has ₹10 lakh in outstanding invoices due in 60 days. A factoring company might buy these receivables for ₹9.5 lakh immediately. They then collect the full ₹10 lakh from your customers when due. You get instant liquidity minus the factoring fee, and the factor assumes the collection responsibility.

Discounting bills of exchange 🔗

Bill discounting allows businesses to get immediate payment for bills drawn on customers. Banks purchase these bills at a discount before their due date, providing working capital to businesses. For example, if you have a bill for ₹1 lakh due in 90 days, a bank might discount it and give you ₹98,000 today, keeping ₹2,000 as their discount charges.

Bank overdraft and cash credit facilities 🔗

Bank overdrafts and cash credit provide flexible access to funds as needed. With an overdraft facility, you can withdraw more money than you have in your account, up to a sanctioned limit. Cash credit works similarly-banks provide working capital loans against the security of inventory or receivables.

These facilities are particularly useful for seasonal businesses. A toy manufacturer might need extra funds before Diwali to build inventory but require less during other months. A cash credit facility allows borrowing only when needed and paying interest only on the amount used, offering tremendous flexibility.

Choosing the right financing mix 🔗

Smart businesses don’t rely on a single financing method. They create a balanced capital structure combining long-term stability and short-term flexibility. A growing company might issue equity shares for permanent capital, take term loans for expansion projects, use retained earnings for modernization, and maintain credit facilities for daily operations.

The key is matching the financing source to its purpose. Long-term assets should be financed through long-term sources, while working capital needs are best met through short-term arrangements. Understanding these options helps businesses make informed decisions that support growth without creating unsustainable debt burdens.

What do you think? If you were starting a business, which financing method would you prioritize first and why? How would you balance the need for capital with concerns about maintaining control and managing risk?

References

1. https://www.bajajfinserv.in/difference-between-shares-and-debentures
2. https://www.bajajbroking.in/blog/difference-between-shares-and-debentures
3. https://www.axistrustee.in/single-post?url=navigating-financial-waters—raising-funds-through-debentures-
4. https://www.businessmanagementideas.com/financial-management/raising-of-finance-for-a-company-12-methods/6912
5. https://www.geeksforgeeks.org/business-studies/retained-earnings-meaning-features-advantages-and-limitations/
6. https://commerceatease.com/retained-earnings/
7. https://www.tradefinanceglobal.com/posts/invoice-finance-versus-bill-discounting/
8. https://www.m1xchange.com/bill-discounting/
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