Finance and Financial System - Meaning and Features [AHSEC Class 11 Finance notes 2025 Exam]

AHSEC Class 11 Finance Notes
Unit 1: Finance and Financial System

1. Define Business Finance. Why do business needs funds? Mention its merits.

Ans: According to Howard and Upton, “Business Finance involves a set of administrative functions in an organisation which relate with the arrangement of cash and credit so that the organisation may have the means to carry out its objectives as satisfactorily as possible”.

Need of Business finance:

Business needs funds to purchase assets and to run day to day operations of the business for the smooth functioning. The needs of the business can be classified as:

a) Fixed capital needs to acquire fixed assets.

b) Working Capital Needs for day to day management of the company.

Merits of Business Finance

a.       Finance helps the firm to meet its liabilities on time.

b.       Smooth flow of business activities.

c.       Use of Business opportunities.

2. Briefly explain various sources from which companies may raise long term capital.

Ans: There are two sources of finance: Long term finance and Short term finance

1) Sources of Long Term Finance:

- Equity Shares

- Preference Shares

- Retained Shares

- Debentures

- Term loans 

- Loan from Financial institutions

a) Equity shares: Equity shares are instruments to raise equity capital. The equity share capital is the backbone of any company's financial structure. Equity capital represents ownership capital. Equity shareholders collectively own the company. They enjoy the reward of ownership and bear the risk of ownership. The equity share capital is also termed as the venture capital on account of the risk involved in it. The equity shareholders’ liability, unlike the liability of the owner in a proprietary concern and the partners in a partnership concern, is limited to their capital contribution.

b) Preference Shares: According to Sec. 43 (a) of the Companies Act 2013, a share that carries the following two preferential rights is called ‘Preference Share’:

(i) Preference shares have a right to receive dividend at a fixed rate before any dividend given to equity Shares.      

(ii) Preference shares have a right to get their capital returned, before the capital of equity shareholders is returned in case the company is going to wind up.

In case of preference shares, the rate of dividend is fixed and the dividend on these shares must be paid before any dividend is paid to equity shareholders. Directors, however, may decide not to pay any dividend to any class of shareholders even if there are sufficient profits.

c) Retained Earnings: Retained earnings are internal sources of finance for any company. Actually is not a method of raising finance, but it is called as accumulation of profits by a company for its expansion and diversification activities. Retained earnings are called under different names such as self-finance; inter finance, and plugging back of profits.  As prescribed by the central government, a part (not exceeding 10%) of the net profits after tax of a financial year have to be compulsorily transferred to reserve by a company before declaring dividends for the year.

d) Debentures: Debentures are debt securities issued by a joint stock company. Amounts collected by way of debentures form part of the loan capital of a company and are repayable after a fixed period. Debenture holders get fixed rate of interest on their debentures as a charge against profit. They are creditors of the company.

Bonds, like debentures, is an acknowledgement of debt issued under the common seal of a company.  The only difference between bonds and debentures is that rate of interest is not pre-determined in case of bond, but in case of debentures rate of interest is fixed.

e) Term Loans: A loan which is financed by the banks and financial institutions for medium term upon the primary security of assets and collateral security of other assets is known as term loan. This type of loan is primarily used for expansion of business that is why it is also called project financing. A fixed rate of interest is charged on term loans and it is always payable in installments.

2) Sources of Raising Short Term Finance

- Trade creditors

- Customers Advances

- Commercial Banks

- Finance Companies

- Commercial Paper house

- Personal Loan Companies

- Government institutions

- Factors or Brokers

Sources of Short Term Financing

a) Trade Creditors: Trade creditors are probably the most important single source of short term credit. Trade creditors are those business establishments which sell good to others on credit. That is, they do not require payment on the spot; rather they are to be paid after some days from the date of sale.

b) Customers Advances: Customers often finance the seller through advance payment for the goods. The prices of the goods to be purchased are paid in advance, i.e. before the receipt of the goods. This practice is prevalent where the seller does not wish to sell goods without prepayment and the buyer also cannot purchase goods from other sources.

c) Commercial Banks: The commercial banks of a country generally supply funds to the business concerns on a short-term basis, either with security or without security if the customer is financially established. The banks, collecting scattered savings of the people, invest a portion of the deposits in the business for a short period of time.

d) Finance Companies: Finance companies usually lend money to business. They are specialized financial institutions and their primary function is to advance funds to the business

e) Commercial Paper House: They are specialized financial agencies and they are created to purchase promissory notes and to sell them, in turn, to other investors who desire to have some shot of short-term liquid assets. The firm having high credit standing can use this source for obtaining short-term funds.

f) Personal Loan Companies: These companies make small loans to individual generally for consumption purposes. The small business undertakings can procure fund form such companies

g) Governmental Institutions: There are some governmental and semi-governmental corporations which are authorized to advance short term funds to business concerns. Their importance is of course not so much less than other sources.

h) Factors or Brokers: In one basic respect, factoring is different from other forms of financing. In other forms funds are granted to one individual largely on the basis of his property. Factoring is based on a different philosophy. In considering a company’s request for funds we are more interested in the men behind the company their ability, their hopes and aspirations for the future.

i) Miscellaneous Sources: There are many more sources from which can secure funds for short period. They are—friend and relatives, public deposits, loan from officer and the company directors and foreign exchange banks.

3. What is financial system? What are its features?

Ans: Meaning of financial system:

The financial system is possibly the most important institutional and functional vehicle for economic transformation. Finance is a bridge between the present and the future and whether the mobilization of savings or their efficient, effective and equitable allocation for investment, it the access with which the financial system performs its functions that sets the pace for the achievement of broader national objectives.

A financial system or financial sector functions as an intermediary and facilitates the flow of funds from the areas of surplus to the deficit. It is a composition of various institutions, markets, regulations and laws, practices, money manager analyst, transactions and claims and liabilities.

Features of financial system

The features of a financial system are as follows

1. Financial system provides an ideal linkage between depositors and investors, thus encouraging both savings and investments.

2. Financial system facilitates expansion of financial markets over space and time.

3. Financial system promotes efficient allocation of financial resources for socially desirable and economically productive purposes.

4. Financial system influences both the quality and the pace of economic development.

4. What are various functions of financial system?

Ans: FUNCTIONS OF FINANCIAL SYSTEM

Good financial system search in the following ways:

1. Promotion of liquidity:  The major function of financial system is the provision of money and monetary assets for the production of goods and services. There should not be any shortage of money for productive ventures. In financial language, the money and monetary assets are referred to as liquidity. The term liquidity refers to cash or money and other assets which can be converted into cash readily without loss of value and time.

2. Link between savers and investors: One of the important functions of financial system is to link the savers and investors and thereby help in mobilizing and allocating the savings effectively and efficiently. By acting as an efficient medium for allocation of resources, it permits continuous up gradation of technologies for promoting growth on a sustained basis.

3. Information available: It makes available price- related information which is a valuable assistance to those who need economic and financial decision.

4. Helps in projects selection: A financial system not only helps in selecting projects to be funded but also inspires the operators to monitor the performance of the investment. It provides a payment mechanism for the exchange of goods and services, and transfers economic resources through time and across geographic regions and industries.

5. Allocation of risk: One of most important function of the financial system is to achieve optimum allocation of risk bearing. It limits, pools, and trades the risks involved in mobilizing savings and allocating credit. An effective financial system aims at containing risk within acceptable limit and reducing cost of gathering and analyzing information to assist operators in taking decisions carefully.

5. What are various components or elements of financial system?

Ans: Components or Elements or Structure of Indian Financial System

The formal financial system comprises financial institutions, financial markets, financial instruments and financial services. These constituents or components of Indian financial system may be briefly discussed as below:

A. Financial Institutions: Financial institutions are the participants in a financial market. They are business organizations dealing in financial resources. They collect resources by accepting deposits from individuals and institutions and lend them to trade, industry and others. They buy and sell financial instruments. They generate financial instruments as well. They deal in financial assets. They accept deposits, grant loans and invest in securities.

On the basis of the nature of activities, financial institutions may be classified as: (a) Regulatory and promotional institutions, (b) Banking institutions, and (c) Non-banking institutions.

1. Regulatory and Promotional Institutions: The two major Regulatory and Promotional Institutions in India are Reserve Bank of India (RBI) and Securities Exchange Board of India (SEBI). Both RBI and SEBI administer, legislate, supervise, monitor, control and discipline the entire financial system.

2. Banking Institutions: Banking institutions mobilise the savings of the people. They provide a mechanism for the smooth exchange of goods and services. They extend credit while lending money. They not only supply credit but also create credit.

3. Non-banking Institutions: The non-banking financial institutions also mobilize financial resources directly or indirectly from the people. They lend the financial resources mobilized. They lend funds but do not create credit. Companies like LIC, GIC, UTI, Development Financial Institutions, Organisation of Pension and Provident Funds etc. fall in this category.

B. Financial Markets: Financial markets are another part or component of financial system. Efficient financial markets are essential for speedy economic development. It facilitates the flow of savings into investment. Financial markets bridge one set of financial intermediaries with another set of players. Financial markets are the backbone of the economy. This is because they provide monetary support for the growth of the economy.

Classification of Financial Markets: There are different ways of classifying financial markets. There are mainly five ways of classifying financial markets.

1. Classification on the basis of the type of financial claim: On this basis, financial markets may be classified into debt market and equity market.

Debt market: This is the financial market for fixed claims like debt instruments.

Equity market: This is the financial market for residual claims, i.e., equity instruments.

2. Classification on the basis of maturity of claims: On this basis, financial markets may be classified into money market and capital market.

Money market: A market where short term funds are borrowed and lend is called money market. It deals in short term monetary assets with a maturity period of one year or less. Liquid funds as well as highly liquid securities are traded in the money market. Examples of money market are Treasury bill market, call money market, commercial bill market etc.

Capital market: Capital market is the market for long term funds. This market deals in the long term claims, securities and stocks with a maturity period of more than one year.

3. Classification on the basis of seasoning of claim: On this basis, financial markets are classified into primary market and secondary market.

Primary market: Primary markets are those markets which deal in the new securities. Therefore, they are also known as new issue markets.

Secondary market: Secondary markets are those markets which deal in existing securities. Existing securities are those securities that have already been issued and are already outstanding. Secondary market consists of stock exchanges.

4. Classification on the basis of structure or arrangements: On this basis, financial markets can be classified into organised markets and unorganized markets.

Organised markets: These are financial markets in which financial transactions take place within the well-established exchanges or in the systematic and orderly structure.

Unorganised markets: These are financial markets in which financial transactions take place outside the well-established exchange or without systematic and orderly structure or arrangements.

5. Classification on the basis of timing of delivery: On this basis, financial markets may be classified into cash/spot market and forward / future market.

Cash / Spot market: This is the market where the buying and selling of commodities happens or stocks are sold for cash and delivered immediately after the purchase or sale of commodities or securities.

Forward/Future market: This is the market where participants buy and sell stocks/commodities, contracts and the delivery of commodities or securities occurs at a pre-determined time in future.

6. Other types of financial market: Apart from the above, there are some other types of financial markets. They are foreign exchange market and derivatives market.

Foreign exchange market: Foreign exchange market is simply defined as a market in which one country’s currency is traded for another country’s currency.

Derivatives market: It is a market for derivatives. The important types of derivatives are forwards, futures, options, swaps, etc.

C. Financial Instruments (Securities): Financial instruments are the financial assets, securities and claims. They may be viewed as financial assets and financial liabilities. Financial assets represent claims for the payment of a sum of money sometime in the future (repayment of principal) and/or a periodic payment in the form of interest or dividend. Financial liabilities are the counterparts of financial assets. They represent promise to pay some portion of prospective income and wealth to others. Financial assets and liabilities arise from the basic process of financing.

D. Financial Services: The development of a sophisticated and matured financial system in the country, especially after the early nineties, led to the emergence of a new sector. This new sector is known as financial services sector. Its objective is to intermediate and facilitate financial transactions of individuals and institutional investors. The financial institutions and financial markets help the financial system through financial instruments. The financial services include all activities connected with the transformation of savings into investment. Important financial services include lease financing, hire purchase, instalment payment systems, merchant banking, factoring, forfaiting etc. 

6. Explained the role of financial system in economic development?

Ans: Role and Importance of Financial System in Economic Development

1. Helps in Capital Formation: It links the savers and investors. It helps in mobilizing and allocating the savings efficiently and effectively. It plays a crucial role in economic development through saving-investment process. This savings – investment process is called capital formation. It promotes the process of capital formation.

2. Growth of capital market and money market:  Business firms need fixed and working capital to finance it investment and business activities. These funds can be raised through the use of financial system. Long term funds can be raised through capital market and short term funds can be raised through money market.

3. Corporate Growth: It helps to monitor corporate performance. It provides a mechanism for managing uncertainty and controlling risk.

4. Balance regional development: It provides a mechanism for the transfer of resources across geographical boundaries. It helps in balance regional development of the countries.

5. Employment Growth: A proper functioning financial system helps in generating employment in both organised and unorganised sector by providing funds to the growing business houses and industries.

6. Promotes savings: It helps in lowering the transaction costs and increase returns. This will motivate people to save more.

7. What are the weakness of Indian Financial system?

Ans: Weaknesses of Indian Financial System

Even though Indian financial system is more developed today, it suffers from certain weaknesses. These may be briefly stated below:

1. Lack of co-ordination among financial institutions: There are a large number of financial intermediaries. Most of the financial institutions are owned by the government. At the same time, the government is also the controlling authority of these institutions. As there is multiplicity of institutions in the Indian financial system, there is lack of co-ordination in the working of these institutions.

2. Dominance of development banks in industrial finance: The industrial financing in India today is largely through the financial institutions set up by the government. They get most of their funds from their sponsors. They act as distributive agencies only. Hence, they fail to mobilise the savings of the public. This stands in the way of growth of an efficient financial system in the country.

3. Inactive and erratic capital market: In India, the corporate customers are able to raise finance through development banks. So, they need not go to capital market. Moreover, they do not resort to capital market because it is erratic and inactive. Investors too prefer investments in physical assets to investments in financial assets.

4. Unhealthy financial practices: The dominance of development banks has developed unhealthy financial practices among corporate customers. The development banks provide most of the funds in the form of term loans. So there is a predominance of debt in the financial structure of corporate enterprises. This predominance of debt capital has made the capital structure of the borrowing enterprises uneven and lopsided. When these enterprises face financial crisis, the financial institutions permit a greater use of debt than is warranted. This will make matters worse.

5. Monopolistic market structures: In India some financial institutions are so large that they have created a monopolistic market structures in the financial system. For instance, the entire life insurance business is in the hands of LIC. The weakness of this large structure is that it could lead to inefficiency in their working or mismanagement. Ultimately, it would retard the development of the financial system of the country itself.

6. Other factors: Apart from the above, there are some other factors which put obstacles to the growth of Indian financial system. Examples are:

a. Banks and Financial Institutions have high level of NPA.

b. Government burdened with high level of domestic debt.

c. Cooperative banks are labelled with scams.

d. Investors’ confidence reduced in the public sector undertaking etc.

e. Financial illiteracy.