Borrowed Funds
1. Meaning of Borrowed Funds
Imagine you run a highly successful chain of retail supermarkets in Ranchi and wish to expand operations by opening three new branches across Jharkhand. While your retained earnings and owners' capital might cover some costs, bringing in more equity partners would mean sacrificing your voting control over the company. To expand without losing control, businesses turn to the outside world for loans. This capital, raised through loans or borrowings from external sources, is known as Borrowed Funds (or Debt Capital). Unlike owners' funds, this money does not belong to the company permanently. It comes with a strict, legally binding obligation to pay a fixed rate of interest at regular intervals and to repay the entire principal amount after a specified period, regardless of whether the company makes a profit or suffers a loss.
2. Sources of Borrowed Funds
Businesses require debt for different durations and purposes—ranging from a 10-year loan to build a new factory to a 3-month credit line to purchase raw materials. To meet these varied needs, the financial market offers multiple specialized instruments of borrowing.
- Debentures and Bonds: A debenture is a formal, written acknowledgment of debt issued by a company under its common seal. It contains a contract for the repayment of the principal sum at a specified date and the payment of interest at a fixed rate. They are generally long-term instruments and are often secured against the assets of the company. Bonds are similar to debentures in terms of being debt instruments, but historically they were issued strictly by government bodies (though today, corporate bonds are also common).
- Loans from Financial Institutions: The government has established specialized financial institutions (like IFCI, SIDBI, and State Financial Corporations) specifically to provide industrial finance. These institutions provide long-term and medium-term loans for massive projects like setting up heavy industries or expanding existing plants. They often provide valuable technical and managerial assistance alongside the funds.
- Loans from Commercial Banks: Commercial banks (like SBI, HDFC, ICICI) are the most vital source of medium and short-term finance. They provide funds to businesses in various forms, such as term loans, cash credits, overdrafts, and discounting of bills of exchange. The rate of interest depends on the prevailing market rates and the creditworthiness of the firm.
- Public Deposits: A company can bypass banks and invite the general public directly to deposit their savings with the company for a period ranging from 6 months to 3 years. The interest rates offered are generally higher than bank deposit rates, making it attractive for the public, while the cost of borrowing remains lower for the company than bank loans. They are entirely unsecured.
- Trade Credit: This is the credit extended by one trader to another for the purchase of goods and services. It facilitates the purchase of supplies without immediate payment (e.g., raw materials bought on a 30-day credit period). It is a vital, extremely common source of short-term financing that arises naturally in day-to-day business operations.
- Inter Corporate Deposits (ICD): These are unsecured short-term deposits made by one corporate entity with another. Companies with surplus funds lend to companies facing a temporary shortage of cash, usually for periods up to six months.
3. Distinguishing Owners' Funds and Borrowed Funds
Choosing the correct mix of capital is one of the most critical decisions an entrepreneur will make. Relying too heavily on borrowed funds increases the risk of bankruptcy due to fixed interest burdens, while relying only on owners' funds dilutes control and may limit growth. Understanding the stark differences between these two sources is fundamental to corporate financial planning.
| Basis of Distinction | Owners' Funds (Equity) | Borrowed Funds (Debt) |
|---|---|---|
| Meaning | Funds contributed by the owners/shareholders and accumulated retained earnings. | Funds raised through loans, debentures, or credit from external parties. |
| Time Period | Permanent capital. It remains with the business until liquidation. | Provided for a specific, pre-determined period (short, medium, or long term) and must be repaid. |
| Reward / Return | Return is paid in the form of Dividends, which fluctuate based on the company's profits. | Return is paid in the form of Interest, which is fixed and compulsory regardless of profits. |
| Risk Profile | High risk for investors (they are paid last), but low financial burden on the company. | Low risk for lenders (guaranteed return), but high financial burden on the company. |
| Control & Voting Rights | Contributors (Equity Shareholders) get full voting rights and control the management. | Contributors (Debenture holders/Banks) get no voting rights and do not control management. |
| Security / Charge on Assets | No security is required to be offered against owners' funds. | Usually secured by creating a fixed or floating charge on the assets of the company. |
Real-World Context & Terminology
Essential Acronyms:
ICD (Inter Corporate Deposits) IFCI (Industrial Finance Corp. of India) SIDBI (Small Industries Development Bank of India)Practical Application:
When an Indian corporation like L&T builds massive infrastructure, they rarely use their own cash reserves entirely. Instead, they issue Debentures to the public and secure large Term Loans from syndicates of commercial banks to fund the long-term construction phase.
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