Sources of finance

Needs of finance

• In our present day economy finance is defined as the provision of money at the time when it is required. every enterprise whether big, small or medium needs finance to carry on its operation.

• In fact, finance is so indispensable today that is rightly said that it is the life blood of an enterprise.

Capital required for a business can be classified under two main categories:-

1. Fixed capital2. Working capital

Long term funds are required to create production facilities through purchase of fixed assets such as plant ,machinery,

land and furniture etc. Funds are also needed for short term purposes

for the purchase of raw material, payment of wages and other day to day expenses.

SOURCES OF FINANACEAccording to period

short- term medium –term long- term1.Bank credit 1.issue of debentures 1.issue of shares2.Cutomer advances 2.issue of preference shares 2.issue of deb.3.Trade credit 3.bank loans 3.retained earning 4.Factoring 4.public deposits 4.loans from

5.Commercial credit 5. loans financial institutions

According to ownership

• Owned capital - shares capital, retained earnings , profits and surpluses etc.

• Borrowed capital -debentures ,bonds ,publics deposits , loans etc.

According to sources of finances

• Internals sources such as retained earnings, profits, depreciations funds etc.

• Externals sources- shares, debentures, public deposits and loans etc

According To mode of financing

• Externals financing- Financing through raising of corporate securities such as shares.

• Internals financing- Financing through earnings , capitalization of profits.

• Loans financing through raising of long term and short term loans.

Internal sources of Finance

• Owners’ funds– When business persons invest some of their own

money (cash in hand ) in their business. Even they can obtain the funds after selling their personal belongings - e.g. a car.

• Reinvested profits– once the business is up and running, any profits

it makes can be used to finance its activities

External Sources

Ordinary Shares (Equities):1. Ordinary shareholders have voting rights2. Dividend can vary3. Last to be paid back in event of collapse4. Share price varies with trade on stock exchange

Preference Shares:1. Paid before ordinary shareholders2. Fixed rate of return3. Cumulative preference shareholders – have right to

dividend carried over to next year in event of non-payment

New Share Issues – arranged by merchant or investment banks

Rights Issue – existing shareholders given right to buy new shares at discounted rate

Bonus or Scrip Issue – change to the share structure – increases number of shares and reduces value but market capitalisation stays the same.

Venture Capital

Foreign Direct Investment (FDI)

Foreign Institution Investors (FIIs)

Disinvestment

Loans (Represent creditors to the company – not owners)

1. Debentures – fixed rate of return, first to be paid

2. Bank loans and mortgages – suitable for small to medium sized firms where property or some other asset acts as security for the loan

3. Merchant or Investment Banks – act on behalf of clients to organise and underwrite raising finance

4. Government – may offer loans in certain circumstances

5. Grants

SECURITY FINANCING

OWNERSHIP SECURITIES OR CAPITAL STOCK.• Equity shares.• Preference shares.• No par stock,

• deferred shares.CREDITORSHIP SECURITIES OR DEBT CAPITAL.• Debentures.

OWNERSHIP SECURITIES• The term ownership securities also known as capital stock represent

share .shares are the most universal form of raising long term funds from the market .every company ,except a company limited by guarantee ,has a statutory right to issue shares.

• According to Farewel : A shares is the interest of a shareholders in the company measured by a

sum of money ,for the purpose of liability in the first place and of interest in the second.

Long term sources

• Issue of shares• Issue of debentures • Retain earning• Loan from specialized financial institutions.

Types of Equity Shares• Authorized share capital

• Issued share capital

• Subscribed share capital

• Paid up share capital

Issue price of shares: The price at which share is issued in the market. • Paid up share capital = issue price * no. of ordinary shares. • Issue price has two components

1. Par value 2. Share premium

Par value is the price per ordinary share stated in the memorandum of association. Generally they are in the denomination of 10 or 100. Any amount in excess of par value is called the share premium.

Shareholders equity = paid up share capital + share premium + reserves and surplus = Net worth

Book value per share = Net worth / no. of ordinary shares Market value of a share is the price at which it trades in the

market. It is generally based upon the expectations about the performance of the economy in general and company in particular.

Equity share

• It is known as ordinary share or common share, represents the owners’ capital in a company. The holder of these shares are the real owner of the company. Equity share holder are paid dividend after paying it to the preference share holders. Equity share capital can not be redeemed during the lifetime of the company.

Features of Equity Shares

• Residual claim to income• Residual claim on assets• Right to control• Voting system• Pre-emptive right• Limited liability

Characteristics of equity shares

• Also known as ordinary shares.• Represents the owner’s capital of the

company.• Can not be redeemed during the life time of

the company.• Are paid dividend after payment to preference

shareholders• More risky as compared to preference shares.

Advantages of equity shares.• Equity shares do not create any obligations to pay a fixed rate of dividend.

• Equity shares can be issued without creating any charge over the assets of the company.

• Equity shareholders are the real owners of the company who have the voting rights .

• It is a permanent sources of capital and the company has not to repay it except under liquidation.

Disadvantages

• As equity capital cannot be redeemable ,there is a danger of over capitalization.

• Investors who desires to invest in safe securities with a fixed income have no attraction for such shares.

• A company cannot take the advantage of trading on equity.

Net Shell-Equity- It is a permanent source of fund without any

repayment liability- It does not involve any obligatory dividend

payment

- high cost of fund reflecting the high required rate of return of investors as a compensation for higher risk

- High floatation cost in terms of underwriting, brokerage and other issue expenditure

- Dilution of control

Method of Raising Capital

• By issue of prospectus

• Rights issue of equity shares.

• Private placement of shares

Initial Public OfferBenefits of going public- Access to capital- Respectability- Investors recognition- Liquidity- Signals from the marketCosts of going public- Adverse selection- Dilution- Disclosures- Accountability- Public pressure

Cost of Public Issue• Underwriting Expenses• Brokerage • Fees to the managers to the issue• Fees for registrars to the issue• Printing expenses• Postage expenses• Advertising and publicity expenses• Listing fees• Stamp duty

Rights Issue of Equity Share

• It involves selling of ordinary shares to the existing shareholders.

• Law in India requires that the new ordinary shares must be first issued to the existing shareholders on a prorata basis

• No. of rights = existing share/ new share

Private placement of shares

• It involves sale of shares (or other securities) by a company to few selected investors, particularly the Institutional Investors like the Unit Trust of India (UTI), the Life Insurance Corporation of India (LIC), IDBI etc.

• Private placement has the following advantages- It is helpful to raise small amount of fund- It is less expensive- It is a much faster way of raising fund.

Shareholder A shareholder (or stockholder) is an individual or

company (including a corporation) that legally owns one or more shares of stock in a joint stock company.

Shareholders are granted special privileges depending on the class of stock, including

the right to vote (usually one vote per share owned) on matters such as elections to the board of directors,

the right to share in distributions of the company's income,

the right to purchase new shares issued by the company, and the right to a company's assets during a liquidation

of the company. However, shareholder's rights to a company's assets are

subordinate to the rights of the company's creditors.

Preferential Allotment• An issue of equity or equity related instruments by a listed

company to pre-identified investors who may or may not be the existing shareholders of the company at a pre-determined price is referred to as a preferential allotment.

• Made to promoters, strategic investors, venture capitalist, financial institutions and suppliers

• Rationale- to secure equity participation of those that the company considers desirable, but who may otherwise find it very costly or impractical to buy large chunk of shares in the market.

Preference shares• Preference shares capital: Preference share is the one which satisfies the

following criteria- With respect to dividend it carries a preferential right to be paid which may

be a fixed amount or a fixed rate- On winding up or on repayment of capital a preferential right to be repaid

the amount• As the name suggests, these shares have certain preferences as compare to

other types of share. These shares are given to preferences.• There is a preference for the payment of dividend.• The second preference for these shares is the repayment of capital at the

time of liquidation of company.

Features of Preference Share

• Claims on income and assets• Fixed Dividend• Cumulative dividend• Redemption• Sinking fund• Participation feature• Hybrid form of security (mixture of equity + deb)

FEATURES A fixed rate of dividend is payable on preference shares . Preferences shares have a preference in the payment of capital at the

time of liquidation of company. Preferences shareholders do not have any voting rights ; so they do not

have any say in the management or control of the company . Generally , preference shares resemble shares in respect of maturity.

These are perpetual and the company is not required to repay the amount during its life time.

Hybrid Security

Ordinary share

• Non payment of dividend does not force the company to insolvency

• Dividends are not deductible for tax purpose

• In some cases there is no fixed maturity date.

Debenture

•Dividend rate is fixed like interest as in case of debts.

•Pref shareholders do not share in the residual earnings

•They have claim on income andassets prior to ordinary shareholders

TYPES• Cumulative Preference Shares: these shares have a right to claim dividend

for those years also for witch there have no profits .whenever there are divisible profits ,cumulative pref. shares are paid dividend for all the previous Years in which dividend could not be declared.

• Non cumulative pref. shares :the holders of these shares have no claim for the arrears of dividend.

• Redeemable Preference Shares : if articles of association allow such an issue . The company has right to return redeemable pref. share capital after certain period.

• Irredeemable Pref. Shares: those shares which cannot be redeemed unless the company is liquidated are known As irredeemable pref. shares.

• Convertible pref. shares: the holders of these shares may be given a right to convert their holdings into equity shares after specific period.

• Non-convertible pref. share :the shares which cannot be converted into equity shares are known as non –convertible pref. shares.

Voting rights for preference shareholders

• Every member of a company holding any preference shares has a right to vote only on resolutions placed before the company which directly affect attached to his preference shares

• Apart from this preference shareholders are entitled to vote if dividend has remain unpaid in case of cumulative as well as non cumulative for two years.

Pros

•Risk less leverage advantage

•Dividend post pondability

•Fixed dividend

•Limited voting right

Cons

•Non tax deductibility of dividend

•Commitment to pay dividend

ADVANTAGE• There is no legal obligation to pay dividend on pref.share pref. dividend is

payable only out of distributable profits at the discretion of the management.

• Pref. share provide a long term capital for the company .• There is no liability of the company to redeem pref .share during the life

time of the company.• As no specific assets are pledged against preferred stock.• Pref. shares do not carry voting rights under normal circumstances and

hence there is no dilution of control.

DISADVANTAGES• Cumulative pref. shares become a permanent burden so far as the

payment of dividend in concerned.• In same cases ,pref. shares carry even the voting right and hence the

control and management of the company may be diluted.• The market prices of preference shares much more than that of

debentures.• It is an expensive sources of finance as compare to debt because generally

investor expect a higher rate of dividend on preference shares . • The rate of dividend on preference share is usually lower as comported to

the equity shares.

MEANING OF DEBENTURES A company may raise long term finance through

public borrowings. A debenture holder is a creditor of the company. A fixed rate of interest is paid on debentures. The interest on debenture is a charge on the profit and loss account of the company. The debentures are generally given a floating charge over the assets of the company.

Debenture/bond is a debt instrument indicating that a company has borrowed certain sum of money and promises to repay it in future under clearly defined terms.

Features

• Maturity • Claims on income • Claims on assets• Control • Call feature (redemption of debts on certain price before maturity)

Attributes

• Trust indenture: it is a complex and lengthy legal document stating the conditions under which a bond has been issued.

• It provides the specific terms of agreement such as description of debenture, rights of debenture holder, rights of the issuing company and responsibilities of the trustees.

• Trustees is a bank or financial institution that acts as a third party to the bond to ensure that the issue does not default on its contractual responsibilities to the bond holders.

• Interest: the debenture carries a fixed rate of interest, payment of which is legally binding

• Maturity: It indicates the length of time for redemption

• Debenture redemption reserve: It is a requirement in the debenture indenture to provide for systematic retirement of debenture on maturity.

• Call and put provision: the call/buyback provides an option to the issuing company to redeem the debenture at a specified price before maturity. The put option is the right to the debenture holder to seek redemption at a specified time at a predetermined price.

• Security

• Convertibility

• Credit rating

• Claim on income and assets

Types of debentures

• Simple or Unsecured debentures- These debentures are not given any security on assets. They have no priority as compared to other creditors.

• Secured debentures- These debentures are given security on assets of the company. In case of default in the payment of interest amount debenture holder can sell the assets in order to satisfy their claims.

• Bearer debentures- These debentures are easily transferable. They are just like negotiable instruments.

• Registered debentures- As compared to bearer debentures which are transferred by mere delivery registered debentures require a procedure to be followed for their transfer.

• Redeemable debentures- These debentures are to be redeemed on the expiry of a certain period.

• Irredeemable debentures- These are payable either on the winding up of the company or at the time of any default on the part of the company

Distinction between shares and debentures

SHARES• A share is a part of owned

capital.

• Shareholders are paid dividend on the shares held by them.

• Dividend on share is a charge against profit and loss appropriation account.

DEBENTURES• A debenture is an

acknowledgement of a debt.

• Debenture holders are paid interest on debentures.

• Interest on debenture is a charge against profit and loss account

• Shareholders have voting right.

• Shares are not redeemable during the life of the company.

• At the time of liquidation of the company share capital is payable after meeting all outside liabilities.

• Debenture holder are only creditors of the company.

• Debenture can be redeemed after a certain period.

• Debentures are payable in priority over share capital.

Debentures–Pros and Cons

• Advantages to Debenture holders– Fixed source of Income– Safe Investment– Definite maturity period

• Disadvantages – No voting rights– Creditors not the owners

Advantages

• Debentures provide long term funds to the company.

• The rate of interest payable on debentures is usually lower than the rate of dividend paid on shares.

• Debt financing does not result into dilution of control because debenture holders do not have any voting rights.

• A company can trade on equity by mixing debentures in its capital structure and thereby increase its earning per share.

• Debentures provide a fixed, regular and stable source of income to its investors.

• Many investors prefer debentures because of a definite maturity period.

Disadvantages

• Cost of raising finance through debentures is also high because of high stamp duty.

• The fixed interest charges and repayment of principal amount on maturity are legal obligations of the company. These have to be paid even when there are no profits.

• The prices of debentures in the market fluctuate with the changes in interest rates.

• Uncertainty about redemption also restricts certain investors from investing in such securities.

• Debentures do not carry any voting rights and hence its holders do not have any controlling power over the management of the company.

• Interest on debentures is fully taxable while shareholders may avoid tax by way of stock dividend in place of cash dividend.

Internal Financing

A new company can raise finance only through external sources such as shares, debentures, loans and public deposits. However, an existing concern which needs finance for its future growth and expansion can also generate finance through its internal sources such as retained earnings or ploughing back of profits and depreciation.

Internal Accruals

• Depreciation

• Retained earnings

Advantages • Retained earnings are easily available

internally.• It eliminates issue and transaction cost.• No dilution of controlDisadvantages• Amount that can be raised by way of

retained earning is limited.• Opportunity cost is quite high

Retained Earnings or Ploughing back of profit

It is a technique of financial management under which all profits of a company are not distributed amongst the shareholders as dividend but a part of the profits is retained or invested in the company.

Necessity of Ploughing back

• For the replacement of old assets which have become obsolete.

• For the expansion and growth of business.• For contributing towards the fixed as well as

working capital needs of the company.• For improving the efficiency of plant and

equipment.• For redemption of loams and debentures.

Advantages

• A cushion to absorb the shocks of economy• Economical method of financing• Aids in smooth running of the business• Helps on following stable dividend policy• Flexible financial structure• Safety of investment• Enhance earning capacity• Decrease the rate of industrial failure

Disadvantages

• Over- capitalization• Creation of monopolies• Depriving the freedom of earnings of the

investors• Misuse of retained earning• Evasion of taxes• Dissatisfaction among the shareholder

Depreciation as a source of funds Depreciation may be regarded as the capital cost

of assets allocated over the life of the asset. In simple language it means the gradual decrease in the value of an asset due to wear and tear, use and passage of time. In real sense, depreciation is simply a book entry having the effect of reducing the book value of the asset and the profits of current year for the same amount. To conclude it may be aid that to the extent depreciation helps in effecting saving in the payment of tax and dividend, it may regarded as source of funds.

Loan financing

The third important mode of finance is raising of both short term loans and credit and term loans including medium and short term loans. These sources of finance have been discussed in the following:-

a. Short Term Financingb. Term Loans

a. Short term Loans and Credits Indigenous Bankers Trade Credit Installment Credit Advances Accounts Receivable or factoring Accrued Expenses Deferred Income Commercial Banks Public Deposits

Short term loans and Credits

• Indigenous bankers- Private money leaders and other country bankers used to be the only sources of finance prior to the establishment of commercial banks. They used to charge very high rate of interest and exploited the customers.

• Trade credit- It refers to the credit extended by the suppliers of goods in the normal course of business. As present days commerce is built upon credit arrangement of a firm with its suppliers is an important source of short term finance.

• Installment credit- This is another method by which assets are purchased and the possession of goods is taken immediately but the payment is made in installments over a pre determined period of time. Interest is charged on the unpaid price.

• Advances- Some business houses get advance from their customers and agents against orders and this source is a short term source of finance for them. It is a cheap source of finance and in order to minimise their investment in working capital.

• Factoring or Accounts Receivable Credit- A commercial bank may provide finance by discounting the bills of its customer. A firm gets immediate payment for sales made on credit. Two types of Factoring are recourse and non-recourse factoring.

• Accrued expenses- These are the expenses which are incurred but not yet due and hence not yet paid. These simply represents a liability that a firm has to pay for the services already received by it.

• Deferred incomes- Deferred incomes are incomes received in advance before supplying goods and services. They represents funds received by a firm for which it has to supply goods or service in future.

• Commercial paper- It represents unsecured promissory notes issued by firms to raise short term funds. Commercial paper is a cheaper source of raising short term finance as compared to the bank credit and proves to be effective even during period of tight bank credit.

• Commercial Bank- The major portion of working capital loans are provided by commercial banks. They provided a wide variety of loans tailored to meet the specific requirement of concern such as loans, cash credits, overdrafts and discounting of bills.

• Public deposits-Co’s have been accepting deposits directly from the public by offering higher rates of interest as compared to bank rates.

b. Term Loan

Term Loan

Term loan is a loan made by bank/financial institution to a business having an initial maturity of more than one year.

Obtaining a term loan• An application form containing comprehensive information

about the project is submitted to the financial institution• It contains details like promoters background, particulars of

the industrial concern, particulars of the industrial project, cost of the project, means of financing etc.

• After the application is received a flash report is generated which is a summarization of the loan application. On the basis of this report detailed appraisal of the project is done.

• In the detailed analysis marketing, technical, financial, management and economic feasibility of the project is tested.

• If on appraisal is the project is found feasible then the loan is sanctioned by the bank.

Specialized financial institutions In under developed countries, the need for such

institutions was much more due to a large number of organizational and financial problems. These institutions are also called development banks. They provide loans and also provide help for the development of the business.

Some names of such institutions:-• Industrial finance corporation of india (IFCI)• Industrial credit and investment corporation of india

(ICICI)• State financial corporation (SFC)• Industrial Development Bank of India (IDBI)

Factors affecting choice of financing• Sales stability• Asset structure• Profitability• Control• Taxes• Growth rate• Management attitude• Firm’s internal conditions• Financial flexibility• Market conditions• Prices

Behavior of Current Assets and Financing Pattern

The objective of this topic is to describe various sources of financing current assets.

Current assets can be financed either by short term sources or long term sources. The various short term sources of raising funds like bank overdraft, cash credit, trade credit, accrued expenses are as follows:

Introduction:At any point of time a manufacturing company will have some minimum level of current assets. This level is largely influenced by the operating cycle period of the company concerned and the policy of management to provide some degree of flexibility to the production and sales functions of the company. The minimum level of current assets maintained by a company is more in the nature of fixed assets and, therefore, can be regarded as 'permanent or fixed component' of current assets. For example, cash, receivables and inventory required to carry on the operations without any break. Over and above the minimum level, the current assets of a company vary depending upon the level of activity or operations. For example, a higher level of finished goods inventory will enable the company to cope with the busy period demand for its product. Further, the level of Accounts Receivables will also tend to increase as a result of the increased level of sales. Thus, the level of current assets associated with the tempo of business activity can be regarded as the 'fluctuating or temporary component' of current assets.

This component is likely to be more pronounced in seasonal industries where either the demand for output or the supply of the important input is seasonal in nature. Woolen garment-making companies are characterized by seasonal demand for output while sugar manufacturing companies are characterized by the seasonal nature in the supply of the important input ie. sugarcane

Short-Term Vs. Long-Term Financing• Short-term financing tends to be riskier than long-term

financing:– Uncertainty concerning future rates.– May not be able to renew.

• Use of short-term financing, however, may lead to higher returns:– Most frequently, short-term rates are lower than long-

term rates (i.e., the term structure is normally upward sloping)

– Flexibility: When financing is not required, short-term debt can be paid off.

Approaches to Financing Policy

• Maturity Matching Approach– A general rule of thumb is to use short-term

financing for temporary asset needs, and long-term financing for permanent asset requirements.

• Aggressive Approach– Use more short-term financing.

• Conservative Approach– Use less short-term financing

Other new Innovative sources of finance

Venture Capital Seed Capital Bridge Finance Lease Financing Higher Purchase

Venture capital financing: It is a type of finance available for investors looking for high potential returns and entrepreneurs who need capital as they are yet to go to the public.

Seed Capital: When promoters or entrepreneurs are not able to pay minimum amount, then IDBI has opened scheme of spl. Seed capital assistance.

Bridge Finance: Usually there is a gap between date of sanctioning of a term loan and its disbursement by the bank due to procedural formalities. To bridge the gap commercial banks provides short term loans.

Leasing: It is a process by which a firm can obtain the use of certain

fixed assets for which it must make a series of contractual and periodic rental payments.

Hire purchase: It is a type of financial transaction in which goods are let on hire with an option to the hirer to purchase them.

External SourcesLeasing

• This method allows a business to obtain assets without the need to pay a large lump sum up front

• It is arranged through a finance company

• Leasing is like renting an asset

• It involves making set repayments

• This is a medium-term source of finance

Advantages• Businesses can have the use

of up to date equipment immediately

• Payments are spread over a period of time which is good for budgeting

Disadvantages• Can be expensive• The asset belongs to the

finance company

External SourcesHire Purchase

• This method allows a business to obtain assets without the need to pay a large lump sum up front

• Involves paying an initial deposit and regular payments for a set period of time

• The main difference between hire purchase and leasing is that with hire purchase after all repayments have been made the business owns the asset

• This is a medium-term source of finance

Advantages• Businesses can have the use of up

to date equipment immediately• Payments are spread over a

period of time which is good for budgeting

• Once all repayments are made the business will own the asset

Disadvantages• This is an expensive method

compared to buying with cash

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