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Sources of Finance

Financial Requirements: 1 2 3 Short term Medium-term Long-term


1 2 3 4 5 6 7 8

Bank credit Customer advances Trade Credit Factoring Accruals Commercial paper Deferred Income Installment credit

Medium Term 1 Issue of Debentures 2 Issue of Preference Shares 3 Bank loans 4 Public deposits/Fixed deposits 5 Loans from Financial institutions
Long-Term 1 Issue of Shares 2 Issue of debentures 3 Ploughing-back of profits 4 Loans from specialized financial institutions Security Financing Corporate securities can be classified under two categories (i) Ownership securities Equity Shares Preference Shares (ii) Creditorship securities Debentures

Kinds of Ownership Securities or shares Equity Shares: Equity shares are known as Ordinary Shares . The holders of these shares are the real owners of the company. They have a control over the working of the company. The rate of dividend on these shares depends upon the profits of the company. They may be paid a higher rate of dividend or they may not get anything. These shareholder take more risk as compared to preference shareholders. Equity capital is paid after meeting all other claims including that of preference shareholders. They take risk both regarding dividend and return of capital. Characteristics of Equity Shares: 1 Maturity: Equity shares provide permanent capital to the company and cannot be Redeemed during the life time of the company. Equity shareholders can demand refund of their capital only at the time of liquidation of a company. 2 Claims/Right to Income: Equity shareholders have a residual claim on the income of a Company. They have a claim on income left after paying dividends to preference Shareholders. The rate of dividend on these shares is not fixed, it depend upon the earnings Available after paying dividends on preference shareholders. In many cases, they may not get anything if profits are insufficient; or may get even a higher rate of dividend. They Are known as variable income security.

3 Claim on Assets: Equity shareholders have a residual claim on ownership of companys Assets.In the event of liquidation of a company, the assets are utilized first to meet the Claims of creditors & preference shareholders but everything left, thereafter, belongs to Equity shareholders.
4 Right to control or Voting Rights: Equity shareholders are the real owners of the company. .They have voting rights in the meeting of the company and have a control over the working of the company. The control in case of a company is rest with the Boards of Directors who are Elected by equity shareholders, Directors are appointed by majority votes. Each equity share carries one vote and a shareholder has votes equal to the number of equity share held by him.

5 Pre-emptive Right: To safeguard the interest of equity shareholders & enable them Maintain their proportional ownership, Section 81 of the Companies Act, 1956 provides that Whenever a public limited company proposes to increase its subscribed capital by the Allotment of further shares, such shares must be offered to holders of existing equity shares in proportion. Shares so offered to existing shareholders are called Right Shares and their Prior right to such is known as pre-emptive right.

6 Limited liability: Although equity shareholders are the real owners of the company, Their liability is limited to the value of share they have purchased.If a shareholder has Already fully paid the share price, he cannot be liable further for any losses of the company even at the time of liquidation. Advantages of Equity Shares: 1 Equity shares do not create any obligation to pay a fixed rate of dividend. 2 Equity shares can be issued without creating any charge over the assets of the Company. 3 It is a permanent source of capital and the company has not to repay it except Under liquidation. 4 Equity shareholders are the real owners of the company who have the voting rights. 5 In case of profits, equity shareholders are the real gainers by way of increased dividend. Disadvantages of Equity Shares: 1 If only equity share are issued, the company cannot take the advantage of trading on equity. 2 As equity capital cannot be redeemed, there is a danger of over capitalisation. 3 During Prosperous periods higher dividends have to be paid leading to increase in the value of shares in the market and speculation. 4 Investors who desire to invest in safe securities with a fixed income have no attraction for such shares.

Preference Shares: As the name suggests, these shares have certain preferences as Compared to other types of shares. These shares are given two preferences. There is a preference for payment of dividend. Whenever the company has distributable profits, the dividend is first paid on preference share capital. The second preference for these shares is the repayment of capital at the time of liquidation of a company. After paying outside creditors, preference share capital is returned in full. A fixed rate Of dividend is paid on preference share capital.Preferences shareholder do not have voting rights; so they have no say in the management of the company. Types of Preference Shares: 1 Cumulative Preference Shares: These shares have a right to claim dividend for those years also for which there are no profits. Whenever there are divisible profits, Cumulative preference shares are paid dividend for all the previous years in which Dividend could not be declared. 2 Non- Cumulative Preference Shares: The holders of these shares have no claim for the arrears of dividend. 3 Redeemable Preference Shares: Normally, the capital is paid only at the time of Liquidation.The company has a right to return redeemable preference share capital after a certain period.Neither the company can return the share capital nor the shareholders can demand its repayment.

4 Irredeemable Preference shares: Those shares cannot be redeemed unless the company is liquidated. 5 Participating Preference shares: The holders of these shares participate in the Surplus profits of the company. 6 7 8 Non-participating Preference Shares Convertible Preference Shares Non-Convertible Preference Shares

Features of Preference Shares: 1 Maturity: Generally , preference shares resemble equity shares in respect of maturity. These are irredeemable and the company is not required to repay the amount during its lifetime. It is only at the time of liquidation that a company has to repay the preference shareholder after meeting the claim of creditor but before paying Back the equity shareholders except in case of redeemable preference shares. 2 Claims on Income: A fixed rate of dividend is payable on preference shares. Preference shareholders have prior claim on income(dividend) over equity Shareholders.Whenever the company has distributable profits, the dividend is first Paid on preference share capital.

Claims on Assets: Preference shares have a preference in the repayment of capital at the time of liquidation of a company. Their claim is superior to those of equity Shareholder.But they do not have any right in the surplus assets of the company. Control: Preference shareholders do not have any voting rights; so they do not have any say in the management or control of the company.

Hybrid Form of Security: Preference share capital represents a hybrid form of security. As it includes some features of equity and other of debt financing.It resembles equity in the sense that (i) payment of dividend is not obligatory;(ii) preference dividend is payable only out of distributable profits & (iii) it is not deductible as an expense While determinig tax liability of the company. At the same time , it has certain characteristics of debt financing such as(i) it carrries a fixed rate of dividend like interest;(ii) it entitles to a right to its holder prior to equity Shareholders and (iii) it does not provide a right to vote.
Creditorship Securities: Debentures or Bonds: A debenture is a document under the companys seal which provides for the payment of a principle sum & interest thereon at regular intervals, which is usually secured by a fixed or floating charge on the companys property or undertaking and which acknowledges a loan to the company. A debentureholder is a creditor of the company. A fixed rate of interest is paid on debentures.The interest on debentures is a charge on the profit and loss account of the company.

Features of Debentures or Bond: 1 Maturity: Although debentures provide long-term funds to a company, they mature after a specific period.Generally, the debentures are to be repaid at a definite time as as stipulated in the issue. The company must pay back the principal amount on these Debentures on the given date otherwise the debentureholders may force winding up of the company as creditors. However,a company may issue irredeemable bonds or Debentures which have no maturity date. 2 Claim on Income: A fixed rate of interest is payable on debentures.Unlike shares, a company has a legal obligation to pay the interest on due dates irrespective of its earnings. Even if a company makes no earnings or incurs loss, it is under an obligation to pay Interest to its debentureholders. The default in payment of interest may cause winding up of company because the debentureholders may take recourse to law for the same. 3 Claims on Assets: Even in respect of claim on assets, debentureholders have priorty of claim on assets of the company. They have to be paid first before making any payment to the preference or equity shareholders in the event of liquidation of the Company. However, they have a claim for the principal amount & interest due only and do not have any share in the surplus assets of the company, if any.

4 Control : Since, debentureholders are creditors of the company and not its owners, they do not have any control over the management of the company.They do not have any voting rights to elect the directors of the company. But, at the time of liquidation Of the company they have prior claim over shareholders & if remain unpaid, they may take control over the company. 5 Call feature: Issue of debentures sometimes provide a call feature which entitles the company to redeem its debentures at a certain price before the maturity date. Since, the call feature provides advantages to the company at the expense of its debentureholders, the call price is usually more than the issue price. II Internal Financing: Retained Earnings or Ploughing Back of Profits: The Ploughing Back of Profits is a techique of financial management under which all profits is retained or re-invested in the company.This process of retaining profits year after year & their utilisation in the business is also known as plouging back of profits. Such a phenomenon is also known As Self-Financingor Internal financing .

III Loan Financing: The third important mode of finance is raising of both (i)short-term loans and credits & (ii) term loans including medium & short-term loans. Short term loans and Credits: 1 Trade Credit: Trade credit refers to the credit extended by the suppliers of goods in the normal course of business.As present day commerce is built upon credit, the trade credit arrangement of a firm with its suppliers is an important source of short-term Finance.The credit-worthiness of a firm and the confidence of its suppliers are the Main basis of securing trade credit.It is mostly granted on an open account basis Whereby supplier sends goods to the buyer for the payment to be received in future As per terms of the sale invoice.It may also take the form of bills payable whereby The buyer signs a bill of exchange payable on a specified future date. 2 Instalment Credit: This is another method by which the assets are purchased and the possession of goods is taken immediately but the payment is made in instalments Over a pre-determined period of time.Generally, interest is charged on the unpaid price or it may be adjusted in the price.

Customer Advances: Some business houses get advances from their customers & agents against orders & 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,some firms Having long production cycle, specially the firms manufacturing industrial products prefer to take advance from their customers. Factoring or Accounts Receivable Credit: Another method of raising short-term finance is Through account receivable credit offered by commercial banks and factors. A commercial bank may provide finance by discounting the bills or invoices of its customers. Thus , a firm gets immediate Payment for sales made on credit. A factor is a financial institution which offers services relating to management and financing of debts arising out of credit sales.Factoring is becoming Popular all over the world on account of various services offered by the institutions engaged in it. Factors render services varying from bill discounting facilities offered by commercial banks to a total take over of administration of credit sales including maintenance of sales ledger, collection of accounts receivables , credit control and protection from bad debts , provision of finance and rendering of advisory services to their clients. Accured Expenses or Accurals: Accured expenses are the expenses which have been incured But not yet due and hence not yet paid also. These simply represent a liability that a firm has to Pay for the services already received by it. The most important items of accurals are wages And salaries, interest and taxes. Wages and salaries are usually paid on monthly, fortnightly or weekly basis for the services already rendered by employees. The longer the payment-period, The greater is the amount liability towards employess or the funds provided by them.

In the same manner, accured interest and taxes also constitute a short-term source of finance. Taxes are paid after collection and in the intervening period serve as a good source of finance. Even income-tax is paid periodically much after the profits have been earned. Like taxes, interest is also paid periodically while the funds are Used continuously by a firm, Thus, all the accured expenses can be used as a source of finance.

Deferred Incomes: Deferred incomes are incomes received in advance before supp-lying goods or services in future. These funds increase the liquidity of a firm and Constitute an important source of short-term finance. However, firms having great demand for its products and services and those having good reputation in the market can demand deferred incomes.
Commercial Paper: Commercial paper represents unsecured promisory notes issued by firms to raise short-term funds. In India, the Reserve Bank of India introduced Commercial paper in the Indian money market. But only large companies enjoying high credit rating and sound financial health can issue commercial paper to raise Short-term funds. The Reserve Bank of India has laid down a number of conditions of determine eligibility of a company for the issue of commercial paper. Only a Company which is listed on the stock exchange, has a net worth of atleast Rs. 10 Crores and maximum permissible bank finance of Rs. 25 crores can issue Commercial paper not exceeding 30 per cent of its working capital limit.

The maturity period of commercial paper, in India , mostly ranges from 91 to 180 days. Commercial paper is usually bought by investors including banks, insurance companies Unit trusts and firms to invest surplus funds for a short-period. Commercial paper is a Cheaper source of raising short-term finance as compared to the bank credit . Disadvantage of commercial paper is that is cannot be redeemed before the maturity Date even if the issuing firm has surplus funds to pay back.

Bank Loans: When a bank makes an advance in lump-sum against some security it is called a loan. In case of a loan , a specified amount is sanctioned by the bank to the Customer. The entire loan amount is paid to the borrower either in cash or by credit To his account. The borrower is required to pay interest on the entire amount of loan From the date of the sanction. A loan may be repayable in lump sum or instalments, the interest is calculated at quarterly rests and where repayments are stipulated in Instalments, the interest is calculated at quarterly rests on the reduced balances. Commercial banks generally provide short-term loans upto one year for meeting working capital requirements.But ,now-a-days , term loans exceeding one year are Also provided by banks. The term loans may be either medium-term or long-term loans.

Public Deposits: Acceptance of fixed deposits from the public by all type of manufacturing & non-bank financial companies in the private sector has been a unique feature of Indian financial system.The importance of such deposits in financing of Indian Industries was recognized as early as in 1931 by the Indian Central banking Enquiry Committee. In the recent years many companies have accepted deposits from the public by offering higher rates of interest as compared to banks and post offices To meet their requirements of funds. Inspite of the fact that public deposits are unsecured, more risky, less liquid and without any tax advantage, there has been a tremendous growth both in the amount Of public deposits as well as in the number of companies accepting such deposits. The Public sector( Govt. companies ) have also started accepting public depoists.