Borrowed Funds vs Owner’s Funds: Key Differences and Examples
Borrowed funds are an essential concept in financial management, business studies, and accounting. Understanding borrowed funds is vital for students preparing for board exams, competitive tests, or for anyone wanting to manage business finances effectively. This knowledge helps you distinguish how businesses raise money and the impact on financial statements.
| Source of Borrowed Funds | Examples | Term Type |
|---|---|---|
| Bank Loans | Term Loan, Working Capital Loan | Short, Medium, Long-term |
| Debentures | Secured Debentures, Unsecured Debentures | Long-term |
| Bank Overdrafts | Overdraft Facility, Cash Credit | Short-term |
| Public Deposits | Fixed Deposit from Public | Short to Medium-term |
| Other Borrowings | Bonds, Loans from Financial Institutions | Medium, Long-term |
Borrowed Funds Meaning
Borrowed funds are money raised by a business from external parties. These can be in the form of loans, debentures, or deposits. Unlike owner’s funds, borrowed funds must be repaid, usually with interest, within an agreed period. Using borrowed funds helps businesses meet their capital needs without diluting ownership.
Features of Borrowed Funds
- Must be repaid after a specific period.
- Interest payments are mandatory, regardless of profits.
- Usually require security or collateral (except unsecured loans).
- Lenders do not have any ownership or control in the business operations.
- Suitable for both short-term and long-term needs.
- Appear as liabilities on the balance sheet.
Types and Examples of Borrowed Funds
There are several types of borrowed funds, each serving different business needs. Common examples include loans, debentures, overdrafts, and public deposits. These funds differ based on source, security, and repayment terms.
| Type | Description | Example in Practice |
|---|---|---|
| Bank Loans | Borrowed from banks for fixed or working capital | A manufacturing firm takes a 3-year term loan to buy machinery. |
| Debentures | Debt instrument issued to raise funds from public | A company issues debentures to build a new plant. |
| Overdraft | Flexible short-term borrowing from current account | A trader uses overdraft to manage sudden supplier payments. |
| Public Deposits | Money taken directly from the public for specified periods | A company accepts deposits from customers for 1-2 years. |
| Bonds | Long-term debt security with regular interest | A corporation issues bonds to raise money for expansion. |
Borrowed Funds vs Owner’s Funds
It is important to differentiate between borrowed funds and owner’s funds (equity). Owner’s funds are contributed by business owners or shareholders and do not require repayment. Borrowed funds are liabilities and must be paid back with interest.
| Basis | Borrowed Funds | Owner’s Funds |
|---|---|---|
| Source | External (loans, debentures, deposits) | Internal (owners, shareholders) |
| Repayment | Yes, with interest | No fixed repayment |
| Risk | Business must pay even if no profit | Risk borne by owner/shareholder |
| Control | No voting/control rights | Have control/voting rights |
| Balance Sheet Position | Shown as liability | Shown as equity/capital |
Borrowed Funds in Balance Sheet
In any business’s balance sheet, borrowed funds are listed as liabilities. Short-term borrowings like bank overdraft are shown under current liabilities. Long-term borrowings like debentures and loans appear under non-current liabilities. This helps users identify the business’s debt position and assess its financial risk.
| Balance Sheet Section | Borrowed Funds Example |
|---|---|
| Current Liabilities | Bank Overdraft, Short-Term Loans |
| Non-Current Liabilities | Debentures, Long-Term Loans, Bonds |
Advantages of Borrowed Funds
- Does not dilute ownership in the business.
- Tax benefits as interest paid is tax-deductible.
- Flexibility for meeting various business needs (short, medium, long-term).
- Helps businesses expand operations without large owner investment.
Disadvantages of Borrowed Funds
- Regular interest and principal repayment increases financial risk.
- High borrowings can lead to liquidity or insolvency issues.
- Too much debt can reduce creditworthiness.
Use of Borrowed Funds: Key Examples
- A company borrows from a bank to purchase new equipment.
- Firms issue debentures to build a factory.
- Retailers use overdraft facilities to manage working capital.
Such practical examples are often asked in school exams, case studies, and competitive exams. Understanding when and why to use each type of borrowed fund boosts your application skills.
Application and Exam Relevance of Borrowed Funds
Borrowed funds are frequently tested in CBSE, ISC, and various commerce exams. Students may encounter direct questions, MCQs, and case-study situations. At Vedantu, we simplify complex topics like borrowed funds for easy revision and exam readiness. Consider revising related topics like Balance Sheet and Capital Structure to develop a complete understanding.
In summary, borrowed funds are external sources of finance that play a crucial role in supporting business growth. Knowing their types, features, classification, and impact on financial statements helps you in exams and real-life business decisions. Understanding borrowed funds is an essential part of commerce education, practical financial planning, and business success.
FAQs on What Are Borrowed Funds? Meaning, Features, Types & Examples
1. What is meant by borrowed funds?
Borrowed funds represent money a business obtains from external sources like loans or debt instruments to fund operations or investments. This money must be repaid with interest and may be secured or unsecured.
2. Which is an example of borrowed funds?
Borrowed funds include various sources. Examples are: bank loans, debentures, bank overdrafts, and public deposits. These are all external sources of finance used by businesses.
3. How are borrowed funds shown in the balance sheet?
Borrowed funds appear as liabilities on a company's balance sheet. They're categorized as either current liabilities (short-term) or non-current liabilities (long-term), depending on the repayment schedule.
4. What is the difference between borrowed funds and owners' funds?
Borrowed funds are external financing obtained from lenders, requiring repayment with interest. Owners' funds (equity) represent the owner's investment in the business; they don't need repayment but offer the owner's claim on profits. The key difference lies in the ownership and repayment aspects.
5. What types of borrowed funds are used by businesses?
Businesses utilize various types of borrowed funds, including: short-term loans like bank overdrafts; long-term loans such as term loans; and debentures (bonds) which represent long-term debt. The choice depends on the business needs and the loan terms.
6. What are the sources of borrowed funds?
Sources of borrowed funds include financial institutions like banks (offering loans and overdrafts), public issues of debentures, and attracting public deposits. Each source has its own terms and conditions.
7. What are borrower funds?
Borrower funds (or borrowed funds) refer to external financing acquired by a business entity. It's money obtained from lenders, requiring repayment with interest, and is reflected as a liability on the company's financial statements. They are a key component of a company’s capital structure.
8. What is the meaning of borrowed money?
Borrowed money, synonymous with borrowed funds, is money acquired from external sources, usually with the agreement to repay the principal amount along with interest over a specific period. This is a crucial concept in financial management and accounting.
9. How do borrowed funds affect a company’s capital structure?
Borrowed funds significantly impact a company's capital structure by increasing its debt-to-equity ratio. This influences financial risk, return on equity, and the cost of capital. A high reliance on debt may increase financial risk, while a balanced approach is often preferred for stability.
10. What are the advantages and disadvantages of using borrowed funds?
Advantages of borrowed funds include leveraging external capital for growth, tax benefits due to interest deductions, and maintaining ownership control. Disadvantages include fixed interest payments, potential financial strain if profits decline, and the risk of default.
11. What is the meaning of borrowed fund?
A borrowed fund is simply money obtained from an external source, typically a loan, to finance a business or individual’s needs. Repayment, including interest, is required.
12. Borrowed funds examples?
Examples of borrowed funds include various financial instruments: bank loans, commercial paper, debentures, bonds, and leases. Each has its own implications for the borrower.
