CHAPTER - 8 SOURCES OF BUSINESS FINANCE

CHAPTER - 8

SOURCES OF BUSINESS FINANCE

Introduction

Finance is the life blood of business. In a modern economy finance needed by business finance. It deals with raising of funds as well as utilising it in the most economical and profitable manner. This is called the management function of finance.

Nature and significance of business finance

Today nobody can think of starting a business enterprise or running it without adequate funds to procure machinery, furniture, land and buildings, raw materials, etc.

Finance is required for the following purposes:

i.          Purchase of land, buildings, plant, machinery, etc.

ii.          Towards the cost of inventories

iii.          Company formation

iv.          Raising finance

v.          Purchase of trade mark, goodwill, patents etc.

vi.          Running expenses of business

Types of finance

            Depending on the period and the purpose, finance may be (1) Long term (2) Short term and (3) Medium term finance.

Long-term finance

            Funds which are required to be invested in the business for a long period (for a period exceeding five years) are known as long term finance or fixed capital.

Factors determining long-term finance (Fixed capital)

a)      Nature of business: The nature and character of business determine how much fixed capital is required, e.g., in a manufacturing concern fixed assets like land and buildings, plant and machinery require huge investments.

b)      Size of business: A large-sized business will generally require huge investment in fixed assets as compared to a small-sized business.

c)      Types of goods produced: If simple articles like ink, gum, hair oil, soap, etc., are manufactured, the investment in fixed assets will not be heavy.

d)      Use of technology: Highly sophisticated and computerized machinery calls for large capital investment.

e)      Manner of acquisition of fixed assets: Outright purchase of fixed assets needs larger capital investments.

Short-term Finance (Working Capital)

            Short-term finance or working capital refers to funds needed to meet day to day expenses, to finance production and to pay wages and other expenses.

Factors determining Short Term Finance (Working Capital)

·     Nature or character of business: Public utility undertakings need very limited working capital as they offer only cash sales. Trading and financial firms and manufacturing units require large sum in current assets (Working Capital).

·     Size of business/scale of operation: Greater the size, larger the requirement of short term finance.

·     Manufacturing process/production cycle: Larger the production cycle (process period), greater the amount of working capital required.

·     Working capital cycle: Working capital passes through different phases from raw materials, work in progress, finished goods, sales, debtors, bills receivables and finally into cash.

·     Credit policy: The credit policy of a concern in dealing with its debtors and creditors influences the working capital requirements.

·     Business cycles: In boom conditions more working capital is needed to finance increased sales, rise in prices and business expansion. During depression, business shrinks and less working capital is needed.

·     Earning capacity and dividend policy: High earning capacity generates cash profits which contribute towards working capital.

·     Price level changes: Changes in price level affect working capital requirements.

·     Other factors: Certain other factors like operating efficiency, management capability, irregularities in supply, foreign trade policy, asset structure, banking facilities, etc.,

Medium-term Finance

            Funds may be required for a period between 1 to 5 years for the purpose of modernization of plant and machinery, introduction of a new product, adoption of new or improved methods of production and for conducting advertisement campaigns. Finance required for such purposes is called medium-term finance or medium-term capital.

Sources of Finance

Sources refer to the agencies wherefrom finance is obtained. They may be:

(1) Owners’ funds           (2) Borrowed funds

Owners’ Funds or Ownership Capital

            Owners’ fund or ownership capital consists of the amount contributed by owners and profits reinvested in the business.

Merits

Ownership capital has the following advantages:

1.         It provides risk capital.

2.       It provides permanent capital.

3.       It provides the right to manage and control the business.

4.       It does not need hypothecation of assets as in borrowed capital.

Limitations

1.         In joint stock companies, though a large amount of capital can be raised by issue of shares to the public, the power of control of original investors over management will get reduced.

2.       Owners’ capital is not refundable except in liquidation.

3.       Finding additional capital is often difficult.

Borrowed Funds/Loan Capital

            Borrowed funds refer to funds raised from individuals, banks and financial institutions, and by way of issue of debentures and raising through public deposits.

Merits

1.      It does not affect the owners’ control in management.

2.     Interest deducted before arriving at profit reduces fax liability of the firm.

3.    The amount and time of borrowing can be adjusted to requirements of business. Hence it is a flexible source of finance.

4.     Even when huge profits are made the interest paid is fixed. Hence a higher return to owners.

Limitations

1. Fixed obligations: Periodical payments of interest cannot be avoided even when there is no profit.

2. Security for loans: Company’s assets have to be mortgaged to raise funds. Interest rate is also high.

Sources of Company Finance

            Companies in India raise long-term and medium-term capital by

(1) Issue of shares and debentures  (2) Public deposits

(3) Bank loans  (4) Ploughing back of profits and

(5) Assistance from specialized financial institutions.

            The table below different sources of company finance.

Financial Requirements

Long term	Medium term	Short term
·        Issue of shares ·        Issue of debentures ·        Loan from specialised financial institutions ·        Ploughing back of profits	·        Issue of preferences shares ·        Issue of debentures ·        Public Deposits ·        Bank loans (term loans) ·        Loans from financial institutions	·        Trade credit ·        Bank credit ·        Installment credit ·        Customer advances

Sources of Long-term Finance

            Sources of long-term finance are:

·     Issue of shares

·     Issue of debentures

·     Loans from financial institutions

·     Ploughing back of profits

·     Public deposits

Issue of Shares

            Joint stock companies have to raise a large amount of capital to carry on their business. The share capital of a company is split into a large number of units, called shares. The Companies Act defines it as “a share in the share capital of a company and includes stock”. The person who holds a share is called a shareholder or member. Shareholders are the owners of the company.

Kinds of Shares

Two types of shares are issued by a company to raise capital:

1. Preference shares

2. Equity or ordinary shares

1. Preference Shares

These are shares which carry preferential rights in dividend and repayment of capital on winding up of the company. They are entitled to a fixed rate of dividend before any dividend is paid to ordinary shareholders. The rate of dividend specified in preference shares is not guaranteed.

The different kinds of preference shares:

(a) Cumulative preference shares: These shares enjoy a fixed rate of dividend even if the company does not declare dividend. Arrear dividend will accumulate till it is fully paid. No dividend can be paid to other classes of shares until cumulative preference shareholders are paid.

(b) Noncumulative preference shares: Noncumulative preference shares, also called ordinary preference shares, get fixed rate of dividend, but only out of profits of the current year. Arrears are not carried forward to subsequent years.

(c) Participating preference shares: These shareholders receive the usual dividend at fixed rate in preference to other classes of shares. These shares have two kinds of dividend – One, fixed and the other, fluctuating based on profits earned.

(d) Nonparticipating preference shares: These shareholders get fixed rate of dividend.

(e) Redeemable preference shares: Under Section 80 of the Companies Act a company can issue shares which can be redeemed only out of profits or proceeds of a fresh issue. The amount of redeemable preference shares are repaid after a specified time.

 (f) Irredeemable preference shares: These are preference shares which are not redeemable. The amount on such shares is repayable only at the time of winding up of the company.

(g) Convertible preference shares: Preference shares issued with a right to be converted into equity shares within a specified period are called Convertible preference shares.

(h) Non-convertible preference shares: The preference shares which cannot be converted into equity share are called non-convertible preference shares.

Advantages of Preference Shares

1. Rate of return is guaranteed.

2. They provide long term capital.

3. Management control is not diluted as preference shareholders enjoy only restricted voting rights.

4. They can be redeemed, if necessary.

5. Mortgage of property not needed to issue such shares.

6.  “Trading on equity” can be adopted since fixed rate of dividend is paid.

7. This method of raising capital is most economical as compared to equity shares.

Disadvantages

1. Fixed dividend puts a permanent burden on the company.

2. Shareholders have no control over management.

3. Preference shares are more expensive.

4. Dividend paid cannot be charged as a business expensive.

2. Equity or Ordinary Shares

            Shares without any preferential right in payment of dividend or repayment of capital are known as equity shares or ordinary shares.

Advantages of Equity Shares

1. No obligation to pay a fixed rate of dividend.

2. No mortgage of company’s property for issue of equity shares.

3. A permanent source of capital to be repaid only at the time of winding up.

4. Equity shareholders are the real owners of the company who enjoy voting rights on all matters.

5. In case of good profits, equity shareholders gain increased dividends and appreciation in the value of                               shares.

Disadvantages of Equity Shares

1. No advantage of trading on equity.

2. As equity capital cannot be redeemed there is a danger of over capitalization.

3. Shareholders can disturb the management by manipulating and organizing themselves.

4. Higher dividends lead to increase in share value and speculation.

5. Not attractive to investors who prefer safety and fixed income.

Difference between Equity Shares and Preference Shares

Points	Equity Shares	Preference Shares
1.Nominal value of shares	Generally lower	Generally higher
2. Rate of Dividend	Varies according to the profits of the company	Rate of dividend is fixed
3. Arrears of Dividend	No right to get the arrears of dividend	Holders of cumulative preference shares get arrears of dividend
4. Priority	No priority in dividend and repayment of capital	Priority in payment of dividend and repayment of capital.
5. Redemption	Cannot be redeemed.	Can be redeemed.
6. Element of risk	There is more risk	The risk is comparatively lower.
7.Voting rights	Wider voting rights	Only limited voting rights.
8. Control	Have control over management	No control over the management.
9. Speculation on shares	Highly speculative.	Less speculative.
10.Investors’ preference	Those willing to take greater risk to earn greater dividend will prefer this.	Those people who do not want take risk and expect steady income invest in preference shares.

Debentures

            A debenture may be defined as “an instrument in writing issued by a company under its seal and acknowledging a debt for a named sum of money, and giving an undertaking to repay that summon or after a fixed future date and meanwhile to pay interest thereon at a certain rate per annum at stated intervals.” Debenture capital is divided into a member of equal parts called debentures. Debenture holders get a fixed rate of interest at fixed intervals.

Kinds of Debentures

            A company issues different kinds of debentures based on the terms and conditions of their issue:

1.      Simple or naked or unsecured debentures: Issued without a charge on the assets of the company, these unsecured debentures have no claim on the company’s assets.

2.     Secured or mortgage debentures: issued with a charge on some or whole assets of the company, secured debentures have claim on the assets. The charge may be fixed or floating.

3.    Redeemable debentures: Debentures issued with a condition that they will be redeemed or repaid after a specified period are called redeemable debentures.

4.     Irredeemable debentures: Debentures issued without any stipulation of period of repayment are called Irredeemable debentures.

5.    Bearer debentures: Debentures issued without the name of the owner is bearer debentures. The bearer is owner and the company keeps no record of buyers.

6.    Registered debentures: The names and address of registered debentures holders are entered in the ‘register of debenture holders’. They are not negotiable instruments.

7.     Convertible debentures: Debentures issued with an option to convert them into shares are called convertible debentures.

Advantages of Debentures

1. Debenture holders have no voting rights.

2. Trading on equity is possible.

3. Interest on debentures is an allowable expenditure under Income Tax Act.

4. Debentures can be redeemed at any time when company has surplus funds.

Disadvantages

1. Debenture capital raising is costly because of high stamp duty.

2. Common people cannot buy debentures as they are of high denominations.

3. If the company expects fluctuation in profits, debenture issue is not advisable.

4. Fixed rate of interest is a burden on the company.

RETAINED PROFITS/PLOUGHING BACK OF PROFITS

Creation of reserves by companies out of their profits and using them to meet financial requirements is known as ploughing back of profits or internal financing or self financing.

Merits

1.         Retained profit is more dependable than external sources.

2.       No need of paying dividend on reinvested profits.

3.       No cost involved in raising funds.

4.       Does not dilute ownership and control.

5.       No security needed for raising funds.

6.       Avoids super tax.

7.       Very economical method of financing.

8.       Aids capital formation.

9.       It makes companies financially strong.

Limitations

1.         Retained profits may be misused to manipulate the value of shares.

2.       The company runs the risk of being converted into a monopolistic organization.

3.       It may result in over capitalization.

4.       It may create dissatisfaction among shareholders.

5.       It may be used for tax evasion.

6.       It may be misused.

PUBLIC DEPOSITS

 Industrial and commercial enterprises try to meet their medium term capital requirements by inviting deposits from the public at a higher rate of interest than commercial banks. A company cannot accept deposits for a period less than 6 months and more than 36 months.

Merits

1.      The system of public deposits is very simple involving no legal formalities.

2.     It facilitates payment of higher dividend to shareholders.

3.    It does not create any charge on company’s assets.

Demerits

1.      Deposit raising being inexpensive, companies may do overtrading speculative activities.

2.     Investors are deprived of benefits accruing from good securities.

3.    If companies do not earn good profits, public deposits turnout to uneconomical.

SOURCES OF SHORT-TERM FINANCE

1.      Trade credit: In modern business, granting of credit promotes sales. When creditors grant such a facility    they are in fact financing purchases for a short period, say three or four months.

2.    Bank credit: Money advanced by commercial banks is called “Bank Credit”. It may be in the form of cash, credit, overdraft, loans and discounting of bills.

3.    Short term financial help from finance companies: finance companies also provide short term loans to business enterprises on the security of their assets, by taking into account the value of bills receivables or amounts due from customers.

4.    Installment credit: This is a method by which expensive assets are bought by paying only a small portion on acquisition and the balance in convenient instalments over a predetermined period.

5.    Advances: Manufacturing concerns take advances against orders from their customers.

FACTORING

       The debt collection activity may be entrusted with specialized agencies called factoring organizations.  Factoring is both a financial technique and a management activity. It is a method of converting book debt into cash. This happens when the factoring agency purchases the book debts of the company. They specialize in collection and administration of debt. The individual or the institution which specializes in these activities is called a factor.

Lease Financing

            Leasing has emerged as an important source of long term financing of the corporate enterprises in recent years. It is an arrangement (legal financing) under which a company acquires the right to use an asset without holding title to it. The owner of the asset is called the lessor and the user the lessee. The lessee has to pay a specified amount called lease rent to the lessor for the use of the asset. Payment is made as regular fixed payments over a period of time at the beginning or at the end of  a month, quarter, half year or year. Lease agreement includes periods, cancellation, rental payments, purchase options, maintenance, etc. At the end of the period of lease agreement, the asset reverts to the lessor who is the legal owner of the asset. Leasing represents an alternative to ownership. A lessee can be an individual or a firm. The lessor may be manufacturer of the asset or an intermediary who brings together the manufacturer and the user.

The benefits of lease financing are :

i.          Aversion to risk of ownership : it offers the advantage of placing the risk of obsolescence on the shoulders of the owners

ii.          Avoidance of investment outlays: it enables the lessee firms to make full use of the asset without making immediate payment of huge purchase price.

iii.          Convenience : it is a more convent form of financing than debt financing.

iv.          Strengthening the borrowing positions : since the information regarding the lease of asset is not disclosed in the balance sheet, it strengthens the borrowing position of the lessee company

v.          Tax advantage : The full amount of lease is an admissible deduction under the income tax act.

Commercial paper (CP)

                It is an unsecured promissory note with a fixed maturity period ranging from 3-12 moths. This serves as an important source of short-term finance. Commercial banks and mutual funds actually contribute towards this kind of instrument.

Financial institutions

           These are otherwise known as term lending institutions or development banks. These institutions were set up with core objective of financing projects to bring about rapid industrialization on a long term basis.

Public financial institutions are 

1)     Industrial finance corporation of India(IFCI)

2)    Industrial credit and Investment Corporation of India Limited (ICICI)

3)   Industrial Development Bank of India (IDBI)

4)    Unit Trust Of India (UTI)

5)   Life Insurance Corporation of India (LIC)

6)   National Housing Bank(NHB)

7)    State Financial Corporations(SFCs)

The types of finance provided by these public financial institutions are

  I.     Medium and long term financial assistance to industrial enterprises to reasonable rate of interest

II.     Subscribe to the debenture issue of companies

III.     Subscribe to the share issued by companies

IV.     Underwrite the issue of shares and debentures of companies

V.     Guarantee loans obtained by such companies from other financial institutions and banks

VI.     Loan in foreign currency for the import of machinery.

VII.     Guarantee the purchase of capital goods from foreign countries.

  INTERNAL FINANCING

   International source of finance for both equity and debt.

Funds can be generated from various international sources are:

1)     Commercial banks

             Commercial banks all over the world give foreign currency loans to business enterprises.

2)  International Agencies and Development Banks

                  They provide long- and medium- term loans and grants to promote the development of economically backward areas of different parts of the world.

3)  International Capital Markets

             Organizations including multinational companies rely on international capital markets for their sizeable borrowings.

(a) Global Depository Receipts (GDRs)

            GDRs are equity instruments issued abroad to tap global markets. These are actually indirect offerings. The shares are issued not by individual companies but by Overseas Depository Banks (ODBs).

(b) American Depository Receipts (ADRs)

            American Depository Receipts (ADRs) have become very popular. These are similar to GDRs as they too used to tap international source of finance. GDRs the shares are issued by an overseas bank (depository), which receives dividends, notices, etc. Though both these instruments are similar in many respects, yet they also have some points of difference. ADRs were created to facilitate public issues and traded in USA. GDRs are issued and traded in Euro markets as well as in US. Both industrial and institutional investors can make investment in ADRs. ADRs are more popular because of their simplicity, safety, and liquidity.

(c) Foreign Currency Convertible Bonds (FCCBs)

            These are equity-linked debt securities that are to be converted into equity or depository receipts after a specified period of time. The holder has the option to either convert them into equity shares at a predetermined price or exchange rate or retain them. These bonds are issued in a foreign currency and carry a fixed rate of interest.

FACTORS AFFECTING THE CHOICE OF THE SOURCE OF FUNDS

            Business requires finance on long-term and short-term basis. Therefore, business organizations tap different types of sources of funds is free from limitations.

These factors are:

1.      Cost: Cost involves cost procurement of funds and cost of utilizing the funds.

2.     Financial strength and stability of operations: if the firm is in a sound financial position it may resort to more borrowed funds. The reason is that it will be in a position to repay the principal amount and interest promptly.

3.    Form of organization and legal status: Form of entity and legal status also influence the selection of choice of funds.

4.     Purpose and time period: funds should be produced according to the time period for which funds are required. Short-term needs should be met by funds through trade credit, commercial paper, etc. For long-term finance, sources such as issue of shares and debentures would be more appropriate. Another factor to be considered here is the purpose of fund.

5.    Risk profile: Risk associated with each source of finance should be evaluated. Risk is least in the case of equity shares compared to loans and debentures.

6.    Control: Degree of control required over the business is an important factor to be considered while choosing the source of fund. Issuing equity shares will dilute the ownership and control.

7.     Effect on creditworthiness: Dependence on certain source of fund may affect the creditworthiness of a company.

8.    Flexibility and ease: flexibility and ease with which funds can be obtained is another factor affecting the choice of a source of finance.

9.    Tax benefits : Certain sources of finance carry tax benefits.