Financing

Decisions UNIT 9 SOURCES OF FINANCE

Objectives:
After studying this Unit you should be able to:

• Appreciate the importance of different Sources of Finance

• Understand classification of Sources of Finance under various categories
• Discuss the advantages and disadvantages of different Sources of
Finance
• Explain the ways in which funds can be raised for the smooth and
effective functioning of an enterprise.

Structure:
9.1 Introduction
9.2 Classification of Sources of Finance
9.3 Long Term Sources
9.3.1 Equity Capital
9.3.2 Preference Shares
9.3.3 Debentures
9.3.4 Retained Earnings
9.3.5 Venture Capital
9.3.6 Leasing
9.3.7 Hire Purchase
9.4 Short Term Sources of Finance
9.4.1 Trade Credit
9.4.2 Commercial Paper
9.4.3 Factoring
9.4.4 Public Deposits
9.5 Financing through Financial Institutions
9.5.1 Term Loan
9.5.2 Bank Credit
9.5.3 Bills Discounting
9.5.4 Letter of Credit
9.6 Emerging Sources of Finance
9.6.1 Asset Securitisation
9.6.2 Angel Financing
9.6.3 Crowd Funding
9.6.4 Small Business Credit Cards
9.7 Summary
9.8 Key Words
9.9 Self Assessment Questions
9.10 Further Readings
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 Sources of Finance
9.1 INTRODUCTION
Financial market as discussed in the previous unit is a system of processes
and functions that are usually regulated by rules and guidelines for enabling
participants to transact in financial products and instruments. Traditionally,
transactions used to take place only in unorganized market places. These
unorganized market places were not subject to specific rule or regulation.
When countries developed and as economies evolved, the need to regulate
markets to remove distortions and to facilitate free flow of funds gave rise to
regulatory bodies. The concept of organized markets evolved to entrust
confidence among market participants.

The traditional organized financial markets in India are:

i) Money Markets - for maturity of less than or equal to one year
ii) Capital Markets - for maturity of more than one year. The capital
markets comprises:
a) Equity markets
b) Debt market
The capital markets comprise of the equity markets and debt market. New
equity stock offering is issued in the primary market. The corporates issue
new equity stock for raising capital towards expansion of business activities.
The stocks that are issued are subsequently listed on the Indian equity
exchanges - NSE, BSE, and other regional exchanges - which comprises the
secondary markets. The components of the Indian Financial Markets include
not only the capital markets and money markets, but also the foreign
exchange markets, Insurance, Pension Fund markets, Loan Markets and
Savings and Investment markets.
The funds are required basically for two reasons: one to acquire fixed assets
and the other to run the operations of the business. It is imperative for any
organization to raise funds for the smooth, and effective functioning of the
business. Arranging for the required funds for each department of the
business is highly complex which requires several decisions to be made.
Business usually needs two kinds of finances; the short term and the long
term. There are several factors which will be affecting the requirement of
fund for a business. The quantum of finance needed may depend on several
factors such as; the nature of business, scale of operations, business cycle,
asset’s structure, etc. There are different sources for raising capital for
different purposes.
In the previous unit we have discussed as to how different financial
institutions and markets facilitate the organizations in raising funds from the
market. Here we will be discussing some of these instruments/ sources that
these markets and institutions provide us to finance the business.

9.2 CLASSIFICATION OF SOURCES OF FINANCE

The sources of finance are classified based on period as long, medium and
short-term finance. As per the ownership and control it is classified as Owned 199
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Decisions
funds and borrowed funds. Depending upon the source of generating this
fund it is either internal or ex
external.
ternal. Each of these sources is further classified
as indicated in the Table
Table-9.1 given below:

Time Ownership Source of Generation

•Long Term • Owned •Internal

•Equity • Equity Capital •Equity Capital
•Preference Shares • Preference Capital •Preference Capital
•Internal Accruals • Retained Earnings •Retained Earnings /
•Debenture Bonds • Convertible Debentures Retained Profits
•Term Loans • Venture Fund/ Private Equity •Convertible Debentures
•Venture Funding •Venture Fund or Private
Equity
•Asset Securitisation
International Financing
•International •Borrowed
• Loans from Banks or Financial
Institutions •External
•Medium Term
• Debentures •Reduction of Working
•Debenture Bonds
Capital
•Medium
Medium Term Loans from
•Sale of assets etc.
Banks/ Financial Institutions /
Government •Bonds
•Lease Finance
•Hire Purchase

•Short Term
•Trade Credit
•Short Term Loans
Fixed deposit for less than a year
•Fixed
•Advances
Advances received from
Customers
•Creditors
•Payables
•Factoring Services
•Bill Discounting

Table-9.1:
9.1: Various Sources of Finance/ Financing

We will discuss some of these sources of finance in the subsequent section.

Activity 9.1
Try to identify two or three sources of finance that are applicable to any firm
of your choice.
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9.3 LONG TERM SOURCES

The long
long-term
term finance is raised when the need for funds is for more than five
to ten years. Long
Long-term
term finance is required for acquisition of fixed assets
200 having a life of more than one year or investments which have long-term
long
impact on the earnings of the company. For instance, if a firm wants to buy a Sources of Finance

patent or brand, which in turn contributes to the sales of the firm for a long-
term, it requires long-term funds for such acquisition. Some of the long-term
sources are equity, debt, asset securitization, venture capital, etc. A company
can raise funds through capital market by issuing financial securities such as
shares and debentures. A financial security is a legal document that
represents a claim on the issuer. The corporate securities are broadly
classified into ownership securities and creditorship securities. There are also
securities known as hybrid securities having the mix of the features of
ownership securities as well as creditorship securities. Depending upon the
market conditions and financing strategies, the issuers adopt different
methods.

9.3.1 Equity Capital

Equity share capital is one of the most important sources of raising capital.
Equity capital represents the owner’s equity, which is prerequisite to start a
company. Its holders are residual owners, who have unrestricted claim on
income and assets and who enjoy all the voting power in the company and
thus can control the affairs of the company. It is prerequisite to the creation of
a company. From the corporate perspective, there is no fixed obligation of
funds to be paid to the equity shareholders. It is perpetual in nature. If the
shareholders require funds, they can sell the shares in the secondary markets.
In exceptional cases a company may buyback the shares. A company may
buyback its shares without shareholders' resolution, to the extent of 10% of
its paid-up equity capital and reserves. However, if a company intends to
buyback its shares to the extent of 25% of its paid-up capital and reserves,
then the same must be approved by Shareholder's Resolution. Section 68,69,
and 70 of the Companies Act, 2013 along with rule 17 of the Companies
(Share Capital and Debentures) Amendment Rules 2016, regulate the process
of share buyback for unlisted companies. The buyback of shares listed on
recognised stock exchanges is regulated by SEBI regulation.

Equity share capital is also known as risk capital as the equity shareholders
are exposed to greater amounts of risk, but at the same time they have greater
opportunities for getting higher returns. The obligations of companies
towards their shareholders are to distribute the income left after paying the
claims of all other investors (e.g.: debt) among the equity shareholders. The
equity shares also give shareholders a residual claim on the assets of the
company in case of liquidation. The advantages and disadvantages of equity
shares are as follows:
Advantages:

i) The equity shares are not repayable to the shareholders and thus it is a
permanent capital for the company unless the company opts to return it
through buying its own shares.

ii) The debt capacity of a company depends on its equity including reserves.
Hence, raising of capital through equity enhances the company’s debt
capacity.
201
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Decisions iii) The company has no legal obligation to service the equity by paying a
certain rate of dividend, unlike the debt for which interest is payable.
Therefore, the firm can conserve the cash when it faces the shortages and
pay when it’s earnings are adequate to do so.
Disadvantages:
i) Among the alternative sources of capital, the equity capital cost is high,
because of higher risk, flotation costs, non-deductibility of dividend for
tax purposes, etc.
ii) Investors perceive the equity shares as highly risky due to residual claim
on assets, uncertainty of dividend and capital gains. Therefore, the
company should offer higher returns to attract equity capital.
iii) Addition to equity capital may not raise profits immediately, but will
dilute the earnings per share, adversely affect the value of the company.
iv) In raising of capital by offering equity shares will reduce the power of
promoters control, unless they contribute proportionately, or opt for non-
voting shares which are costlier than ordinary equity shares.

9.3.2 Preference Shares

The preference shares are called quasi-equity having characteristic of both
equity and debt. These shareholders’ get dividend, which is fixed and paid
before anything is paid to equity holders, but they do not have voting rights.
In case a company fails to pay the stated dividends, they may acquire the
voting rights in certain circumstances. The investors can claim stake over the
residual assets, at the time of liquidation of the company before the equity
holders and after the debt holders. They behave like debt instruments because
they carry fixed dividend rates. They behave like equity instruments because
they offer the dividend to the shareholders without any obligation on the
company in case of liquidation.

The advantages and disadvantages of preference share capital are as follows:

Advantages:
i) The dividend rate is fixed, providing a constant rate of income to the
investors. They do not present a major control or ownership problem if
the dividend amount is being paid to them. In certain specific cases
preference share holders have voting rights, but they do not pose any
major control problem for the promoters.
ii) The other advantage of preference shares is that of cumulative dividends.
Cumulative preference shares carry accumulated unpaid dividends year
to year till the company can pay all the dividends including the arrears at
a stated rate.
iii) It helps to maintain the status quo in the control of the equity stock and
reduce the cost of capital as the preferred stock carries lower rate of
dividends as compared to other debt securities, like debentures which
usually carry higher rates of interest.
202 iv) The preference shareholders may have a right to share the surplus profits
 by way of additional dividend and the right to share in the surplus assets Sources of Finance

in the event of winding-up after all kinds of capital have been repaid.

v) The company does not face liquidation or any other legal proceedings, if
it fails to pay preference dividends, as there is no such legal compulsion
to pay preference dividends.

Disadvantages:
i) The preference shareholders do not have voting rights, so there is no
direct control over the management of the company.
ii) They get only a fixed rate of dividend, even if the company enjoys more
profits.
iii) The cumulative preference shares become a permanent burden so far as
the payment of dividend is concerned. The company is under an
obligation to pay the dividends for the unprofitable periods also.

iv) In case, if the company earns returns less than the cost of preference
share capital, it may result in decrease in earnings per share (EPS) for the
equity shareholders.

v) For tax calculation dividend on preference shares is not a deductible

expense, but interest is a deductible expense.

9.3.3 Debentures
Debentures are one of the principal sources of funds to meet long-term
financial needs of companies. Though there is no specific definition of
debenture, according to the Companies Act 1956, the word debenture
includes debenture stock, bonds, and any other securities of a company. Thus,
a debenture is widely understood as a document issued by a company as
evidence of debt to the holder, usually arising out of loan and mostly secured
by charge.

The debentures are instruments for raising debt finance and the debenture
holders are the creditors of the company. Debt provides the capital to a
company with fixed cost liability (Interest to be paid annually/semi-
annually). The debenture holders get interest paid as the payment of interest
is an obligation on the company. But they do not have voting rights which
equity shareholders have. They have claim over the assets of the company
before the equity holders. The obligations of the company issuing debentures
include establishing a Trustee through a trust deed. The trustee, usually a
bank or financial institution is supposed to ensure that the company fulfils its
contractual obligations. Secondly, debentures are backed by
mortgages/charges on the immovable properties of the companies. These
debentures are redeemable in nature with maturity of more than 18 months,
for which the company must create a Debenture Redemption Reserve.

The following are the advantages and disadvantages of debentures:

203
Financing
Decisions Advantages:
i) It is one of the long-term sources of finance having a maturity period
longer than the other sources of finance.
ii) The debenture holders are only creditors of the company and hence they
cannot interfere with the company affairs as they do not have voting
rights.
iii) Further, the debenture holders are entitled to interest at a fixed rate,
which is usually lower than other sources of long-term finance.
iv) The cost of debentures is usually low, as the interest payments on
debentures are tax deductible expenses. Thus, it helps to reduce the tax
burden of the company.
v) In case of liquidation of the company, the debenture holders have
priority over equity shareholders in the distribution of available funds of
the company.
Disadvantages:
i) The interest on debentures is payable even if the company is unable to
earn profit and hence, it may not be suitable to those companies whose
earnings fluctuate considerably.
ii) Secured debentures restrict the company from raising further finance
through debentures, as the assets are already mortgaged to the debenture
holders.
iii) The debenture holders can initiate the legal proceedings against the
company, if it defaults on its interest payment or principal when they
become due.

9.3.4 Retained Earnings

The companies can raise funds from internal sources, through the retained
earnings, which are ploughing back of profits for future expansion or
diversification activities. Some of the advantages and disadvantages of this
source of finance are:

Advantages:
i) This is the lowest cost of fund and does not involve any flotation cost as
required for raising funds while issuing different types of securities.
ii) If the company uses retained earnings, it is not under any obligation for
payment of dividend or interest on retained earnings.
iii) As there is no implicit cost of retained earnings, the value of share will
increase.
iv) These funds being internally generated, there is a greater degree of
operational freedom and flexibility.

Disadvantages:
i) Excessive use of retained earnings may lead to monopolistic attitude of
204 the company.
ii) If retained earnings are used more it may lead to over capitalization, Sources of Finance

which is symbolic for inefficient working of an organization.

iii) By manipulating the value of shares in the stock market the management
can misuse the retained earnings.

iv) This source of funds is uncertain, as the profits of the business are not
certain.

9.3.5 Venture Capital

Venture capital is usually in the form of equity or quasi-equity instruments in
a new company set-up to commercialise a novel idea. It is investment at the
early-stage in case of high-growth projects, which have high-risk with the
potential high returns over a period ranging from three to seven years. The
risk factor being high, the probability of failure is also high. The venture
capital investment is “hands-on” investment, where the investor mentors and
advises the promoters of the business in which the investment has been made.
The venture capitalist is an investor, who guides the project through its
different stages of growth by identifying avoidable pitfalls and directs the
business along with the possible avenues of growth. The returns to the
venture capitalist are from the handful of the projects, which succeed.

The venture capitalist is a partner, who brings more money to the project.
Many projects, which find it difficult to raise funds from banks and other
financial institutions, approach venture capitalists for assistance. The venture
capitalists conduct a preliminary project appraisal, which includes
verification of whether it is in their investment of the business. Further,
venture capital organization provides value addition in the form of
management advice and contribution of overall strategy. The relatively high
risk will normally be compensated by the possibility of high return in the
form of capital gains in the medium term.
The main features that distinguish venture capital from other sources of
capital market are as follows:
i) Venture capital is a form of equity capital for relatively new companies,
which find it too premature to approach the capital market to raise funds.
However, the basic objective of a venture capital fund is to earn capital
gain, which usually will be higher than interest at the time of exit.
ii) The transfer of existing shares from other shareholders can not be
considered as venture capital investment. The funding should be for new
project or for rapid growth of the business, with cash transferring from
the fund to the company.
iii) All the projects financed by the venture capitalists will not be successful.
However, some of the ventures yield very high return to more than
compensate for the losses on others.
Thus, the venture capital firms, fund both early and later stage financing
requirements of a firm, balancing between risk and profitability. This is an
ideal source of capital for promoters having very good technical and
management skills, with limited financial resources
205
Financing
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Identify the advantages of using venture capital fund for financing the
business.
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9.3.6 Leasing
Leasing provides an alternate method of financing the business to acquire
assets. Instead of borrowing for acquiring assets, it is possible for firms to
acquire the assets on lease. A lease is a contract whereby the owner of an
asset (the lessor) grants to another person (the lessee) exclusive right to use
the asset for an agreed period, in return for the payment of a rent (called lease
rental). The capital assets, like land, buildings, equipment, machinery,
vehicles are the usual assets which are generally acquired on lease basis. The
lessor remains the owner of the asset, but the possession and economic use of
the asset is vested in the lessee.

The advantages and disadvantages of using leasing as a source of finance are

as follows:

Advantages:
There are several benefits derived by the lessee by acquiring the assets on
lease basis, as compared to buying the same, which are discussed as under:
i) If the capital asset is needed for a short period say a year or two, leasing
is a very convenient and appropriate method of acquiring. It dispenses
with the formalities and expenses incurred in purchasing the asset and
selling it soon after the need is over.
ii) In case of owning an asset, the firm bears the risk of the asset becoming
obsolete. In the present age of technological innovations, risks in owning
an asset with outdated and old technology cannot be ignored. Leasing
provides a shield against all these hazards by shifting the risk of
obsolescence of equipment to the lessor.
iii) Under operating or full-service lease, the lessee avails of the
maintenance and other services provided by the lessor, who is well
equipped, qualified, and experienced to provide such services efficiently.
Of course, the lessee pays for such services in the form of higher rentals.

iv) Many leasing companies specialise in leasing a few types of equipment,

machines, or vehicles only. They can easily bargain with the
suppliers/manufacturers, etc., and acquire the assets at better prices and
can economise in other administrative expenses also. The lessee may get
a concession in lease rent based on the economies derived by the lessor.

v) When an asset is acquired on lease basis, lease rentals are shown as an

206
 expense in the firm’s profit and loss account. Neither the leased asset nor Sources of Finance

the liability under the lease agreement is shown in the Balance Sheet.
Hence the debt-equity ratio remains unaffected as compared to a firm
which buys the asset with borrowed funds.

Disadvantages:
i) The lessee undertakes to pay to lessor regularly lease rental, as
consideration for the use of the goods. So, the cost of this is higher as
compared to other sources.
ii) The goods must be returned to the lessor exactly in the same form, after
the lease period is over. The lessee cannot make any considerable
changes to the asset or property as he is not the owner.
iii) The lessor, after handing over possession of the leased asset, remains
owner of the asset throughout the lease period and even thereafter.
iv) After the lease period is over, the lessee will not get the ownership over
the leased asset, though quite a good amount is paid over the years in the
form of lease rentals to the lessor.

9.3.7 Hire Purchase

Hire purchase is another method of acquiring a capital asset for use, without
paying its price immediately. Under hire purchase arrangement goods are let
on hire. The hirer (user) is allowed to pay the purchase price in instalments
and enjoys an option to purchase the goods after all the instalments have been
paid. Thus, the ownership in the asset is passed on to the hirer on payment of
the last instalment. The amount and number of instalments is fixed at the time
of delivering the asset to the hirer. If the hirer makes default in making
payment of any instalment, the seller is entitled to recover the asset from the
hirer. The hirer may, on his own also, return the asset to the hiree without any
commitment to pay the remaining instalments. Thus, the property in the asset
remains vested in the seller (hiree) till the right of purchase is exercised by
the hirer after making payment of all the instalments.

9.4 SHORT TERM SOURCES OF FINANCE

Firms also raise short term funds from banks and other investors. Some of the
methods used to raise short term funds used by firms are as follows:

9.4.1 Trade Credit

Trade credit is used by companies as a short-term source of financing. It is a
credit facility extended by one trader to another for the purchase of goods and
services. Immediate payment is not required in this case. The payables
constitute a current or short-term liability representing the buyer’s obligation
to pay a certain amount on a date after the purchase for value of goods or
services received. They are short-term deferments of cash payments that the
buyer of goods and services is allowed by the seller.
The trade credit is extended in connection with goods purchased for resale or
207
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Decisions for processing and resale, and hence excludes consumer credit provided to
individuals for purchasing goods for ultimate use and instalment credit
provided for purchase of equipment for production purposes. Trade credits or
payables serve as non-interest-bearing source of funds in most cases. They
provide a spontaneous source of capital that flows in naturally during
business in keeping with established commercial practices or formal
understandings.

Advantages:
i) Trade credit could be obtained readily, without extended procedural
formalities. During periods of credit crunch or paucity of working
capital, trade credit from large suppliers can be a boon to small buyers.
ii) Where the suppliers have the advantage of high gross margins on their
products, they would be able to assume greater risks and extend more
liberal credit.
iii) In trade credit, there is no rigidity in the matter of repayment on
scheduled dates. It serves as an extendable, convenient source of
unsecured credit.
iv) Even as the current dues are paid, fresh credit flows in, as further
purchases are made. With a steady credit term and the expectation of
continuous circulation of trade credit-backing up repeat purchases, trade
credit does in effect, operate as long-term source of finance.
Disadvantages:
i) Easy availability of credit may induce a firm to indulge in overtrading,
which may increase the risks of the firm.
ii) The funds generated using trade credit are limited compared to that of
others.
iii) Sometimes it may be a costly source of funding as compared to other
sources.

9.4.2 Commercial Paper

Companies with good credit rating can raise money directly from the market
by issuing commercial papers. It is an unsecured instrument through which
high net worth corporates borrow funds from any person, corporate or
unincorporated body. It is issued in the form of usance promissory note,
which is freely transferable by endorsement and delivery. Its minimum period
of maturity should be 15 days and maximum period is less than a year, it is
issued at a discount to face value.

The commercial papers are unsecured notes but negotiable and hence liquid.
Instruments like commercial papers enable both lenders and borrowers to
move out of the relationship in a short period of time. Since lender and
borrower meet directly, the cost of commercial paper borrowing will be
lesser than working capital loan. Many banks and cash rich companies
participate in commercial papers, which are issued by high-quality
companies. Since they are liquid, even banks are willing to invest money in
208 commercial papers.
9.4.3 Factoring Sources of Finance

The Factoring is essentially a management service designed to help firms

better manage their receivables. It is in fact, a way of off-loading a firm’s
receivables and credit management on to someone else - in this case, the
Factoring Agency or the Factor. Factoring involves an outright sale of the
receivables of a firm to another firm specialising in the management of trade
credit, called the Factor.
Under a typical factoring arrangement, a Factor collects the accounts on the
due dates, effects payments to its client firm on these days and assumes the
credit risks associated with the collection of the accounts. For rendering these
services, the Factor charges a fee which is usually expressed as a percentage
of the total value of the receivables factored. Thus, factoring is an alternative
to in-house management of receivables. Depending upon the inherent
requirements of the clients, the terms of Factoring contract vary, but broadly
speaking Factoring service can be classified as:
a) Non-recourse Factoring: In Non-recourse factoring, the Factor assumes
the risk of the debts going “bad”. The Factor cannot call upon its client-
firm whose debts it has purchased to make good the loss in case of
default in payment by the counter party. However, the Factor can insist
on payment from its client if a part of the receivables turns bad for any
reason other than financial insolvency.
b) Recourse Factoring: In recourse factoring, the Factoring firm can insist
upon the firm whose receivables were purchased to make good any of
the receivables that prove to be bad and unrealisable. However, the risk
of bad debt is not transferred to the factor.
Many foreign and private banks have started providing the Factoring
services. However, there are certain advantages as well as disadvantages
of using Factoring as discussed below:
Advantages:
i) Under the Factoring arrangement the client receives pre-payment upto
80-90 percent of the invoice value immediately and the balance amount
after the maturity period. This helps the client to improve cash flow
position which helps to have better flexibility in managing working
capital funds in an efficient and effective manner.
ii) It reduces administrative cost and time, as a result of this, the company
can spare substantial time for improving the quality of production and
tapping new business opportunities.
iii) When without recourse factoring arrangement is made, the client can
eliminate the losses on account of bad debts. This will help in
concentrating more production and sales. Thus, it will result in increase
in sales, increase in business and increase in profit.
iv) The client can avail advisory services from the Factor by virtue of his
expertise and experience in the areas of Finance and marketing. This will
help them to improve efficiency and productivity of it’s organization.
The above mentioned benefits will accrue to the client provided he 209
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Decisions develops a better business relationship with the Factor, and both have
mutual trust in each other.
Disadvantages:
i) Image of the company may suffer as engaging a Factoring Agency is not
considered a good sign of efficient management.
ii) Factoring may not be of much use where companies or agents have one-
time sales with the customers.
iii) Factoring increases cost of finance and thus cost of running the business.
iv) If the client has cheaper means of finance and credit (where goods are
sold against advance payment), Factoring may not be useful.

9.4.4 Public Deposits

According to the Companies Act, 2013, all types of money received by a
company except the contribution to capital would fall in the category of
deposits. Fixed deposits which are also known as public deposits have
become attractive for companies as well as investors. For the companies,
public deposits are easy form of fund mobilization without mortgaging
assets. For the investors, public deposits provide a simple avenue for
investment in good and popular companies at a better rate of interest without
many formalities as involved in the case of shares and debentures. However,
the public deposits being unsecured, the repayment of deposits and regular
payment of interest are subject to a lot of uncertainty. By presenting false
information some companies manage to collect large deposits from the
gullible public and fail to honour commitments on payments, despite many
regulatory provisions, as contained in the Companies Act and the Companies
(Acceptance of Deposits) Rules, 1975.

9.5 FINANCING THROUGH FINANCIAL

INSTITUTIONS
A company can also source long- and medium-term loans from financial
institutions, like the Industrial Finance Corporation of India (IFCI), State
level Industrial Development Corporations, etc. These financial institutions
can grant loans for a maximum period of 25 years against approved schemes
or projects. Loans agreed to be sanctioned must be covered by securities by
way of mortgage of the company's property or assignment of stocks, shares,
gold, etc. The corporate also has the option of sourcing medium-term loans
from commercial banks against the security of properties and assets. This
method of financing does not require any legal formality except that of
creating a mortgage on the assets.
Following are some of the methods of Financing by Financeial Institutions:

9.5.1 Term Loan

The term loans are granted for medium and long terms, generally above 3
years and are meant for purchase of capital assets for the establishment of
new units and for expansion or diversification of an existing unit. At the time
210 of setting up of a new industrial unit, term loans constitute a part of the
project finance which the entrepreneurs are required to raise from different Sources of Finance

sources. These loans are usually secured by the tangible assets like land,
building, plant, and machinery etc. Now, the banks have the discretion to
sanction term loans to all projects within the overall ceiling of the prudential
exposure norms prescribed by the Reserve Bank of India. The period of term
loans will also be decided by banks themselves. Though term loans are
essentially meant for meeting the project cost, some part of project cost
includes margin for working capital, This means a part of term loans
essentially goes to meet the needs of working capital.

9.5.2 Bank Credit

Banks including the Development Finance Institutions have become chief
source of funds to the corporate sector. In other words, the industrial credit is
a major revenue earner to the banking sector as other types of credit like
agricultural credit are subject to many restrictive conditions and regulations
of RBI and therefore, the margins on such credits are very thin. The banks
extend credit to industries and commercial establishments at varying rates of
interest depending upon the credit worthiness of the borrower as well as
period of loan. The proportion of bank credit in the total funds of the
companies is very high in many a case. The major advantage for the
companies in the bank credit is that it is a flexible source of financing, and it
is relatively easy to mobilize funds through this source. Some of the forms of
Bank credits are:

Overdrafts: This facility is allowed to the current account holders for a short
period. Under this facility, the current account holder is permitted by the
banker to draw from his account more than what stands to his credit. The
excess amount drawn by him is deemed as an advance taken from the bank.
Interest on the exact amount overdrawn by the accountholder is charged for
the period of actual utilisation. The banker may grant such an advance either
based on collateral security or on the personal security of the borrower.
Overdraft facility is granted by a bank on an application made by the
borrower. He is also required to sign a promissory note. Therefore, the
customer is allowed the amount, upto the sanctioned limit of overdraft as and
when he needs it. He is permitted to repay the loan as per his convenience
and ability to do so.

Cash Credit: Cash credit accounts for the major portion of bank credit in
India. The banker prescribes a limit, called the cash credit limit, upto which
the customer-borrower is permitted to borrow against the security of tangible
assets or guarantees. After considering various aspects of the working of the
borrowing firm, i.e., production, sales, inventory levels, past utilisation of
such limit, etc., the banker fixes the cash credit limit. The borrower is
required to provide security of tangible assets. A charge is created on the
movable assets of the borrower in favour of the banker. On repayment of the
borrowed amount in full or in part by the borrower, security is released to
him in the same proportion in which the amount is refunded. However,
banker charges interest on the actual amount utilised by him and for the
actual period of utilisation.
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Financing
Decisions Loans: Loan is a definite amount lent at a time for a specific period and a
definite purpose. It is withdrawn by the borrower once and interest is payable
for the entire period for which it is granted. It may be repayable in
instalments or in lump sum. If the borrower needs funds again, or wants to
renew an existing loan, a fresh proposal is placed before the banker. The
banker will make a fresh decision depending upon the availability of cash
resources. Even if the full loan amount is not utilised the borrower has to pay
the full interest.

9.5.3 Bills Discounting

The bill discounting is an important source of financing trade and business.
Under this form of financing, seller of the goods draws a bill of exchange on
the buyer (who accepts and returns the same to the drawer). Subsequently the
seller of the goods discounts the bill of exchange with bank or finance
company and avail the finance accordingly. Only those bills which arise out
of genuine trade transactions are considered by the banks and finance
companies for discounting purpose.
Parties to a Bill of Exchange are as follows:
i) The drawer draws the bill and ensures that the bill is accepted and paid
according to its tenor. The drawer promises to compensate the holder or
any endorser of the bill if it is dishonoured.
ii) The drawee is a person on whom the bill is drawn, and the drawee
assumes legal obligation to pay the bill, as it shows assent by signing
across the bill for payment at maturity.
iii) The payee is a person to whom or to whose order the bill is payable.
iv) The endorser could be the payee or any endorsee who signs the bill on
negotiation. If the bill is negotiated to several persons who signs it in
turn becomes an endorser. The endorser is liable as a party to the bill.

If the bill of exchange is not endorsed, then drawer and payee will be the
same person.

Advantages:
The advantages of using bill discounting as a source for financing the
business are:

i) Banks usually discount bills at a rate lower than the rate charged for cash
credit. In view of this, drawer of the bill can reduce its cost of funds by
raising the funds through discounting of bills with banks.

ii) Bills seem to have certainty of payment on due dates, and this helps to
have efficient working capital management for the drawer. It also leads
to greater financial discipline as bills are discounted only against genuine
trade transactions as compared with bank overdraft facilities.

iii) The banker is having no risk in lending, as providing finance against bill,
the bank can ensure safety of funds lent. A bill is a legal negotiable
212 instrument with the signatures of two concerned parties, enforcement of
 a claim is easier. Sources of Finance

iv) With recourse to two parties banker face a lower credit risk. In other
words, if the acceptor of the bill fails to make payment on the due date
the bank can claim the whole amount from the drawer of the bill.

v) As a security, the value of a bill is not subject to fluctuations which are

found in case of values of tangible goods and financial securities. The
amount payable on account of a bill is fixed and the acceptor is liable for
the whole amount.

Disadvantages:
i) Financial institutions charge a fee, which becomes a cost to the company.
Thus, the profit margin of the company may decrease.
ii) Bill discounting does not provide any facility or assistance to recover the
unpaid bills.

9.5.4 Letter of Credit

A Letter of Credit(L/C) is a written undertaking given by a bank on behalf of
its customer, who is a buyer to the seller of goods, promising to pay a certain
sum of money provided the seller complies with the terms and conditions
given in the L/C. It is generally required when the seller of goods and
services deals with unknown parties or otherwise feels the necessity to
safeguard his interest.

The banker issuing the L/C commits to make payment of the amount
mentioned therein to the seller of the goods, provided the latter supplies the
specified goods within the specified period and comply with other terms and
conditions. Thus, by issuing letter of credit on behalf of their customers,
banks help them in buying goods on credit from sellers who are quite
unknown to them. The banker issuing L/C undertakes an unconditional
obligation upon himself and charge a fee for the same. The L/Cs may be
revocable or irrevocable. In the latter case, the undertaking given by the
banker can not be revoked or withdrawn

9.6 EMERGING SOURCES OF FINANCE

Technology has led to the development of newer means and ways of
financing business, some of which are discussed below:

9.6.1 Asset Securitization

Securitization is fairly a simple process through which an asset (fixed or
current) is converted into financial claim. In other words, it brings liquidity to
an illiquid asset. The concept is very popular in housing finance. Let us
explain the concept with a simple example. Suppose a housing finance
company has Rs. 100 cr. During the first six months, it accepts the loan
proposals and lent Rs. 100 cr. at an average interest rate of 10% and the
duration of the loan is 15 years. Suppose the housing finance company gets
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Decisions some more loan applications say for Rs. 20 cr. in seventh month. The
company has to look for new source of finance to fund the new loan
proposals since it has already invested the entire capital and converted them
into illiquid long-term 15 years receivables.

Under securitization, an intermediary agency is created, which initially buys

the illiquid asset and against that it issues securities, which are tradeable in
the market through listing. Thus, it is also called asset-backed securities or
mortgage-backed securities. The value of the securities is improved by taking
credit rating and often through insurance cover. Some of the advantages and
disadvantages of securitisation are:

Advantages:
i) Securitization improves operating cycle of the capital in the sense the
housing finance company can recycle the capital several times and
finance more houses without borrowing on its book.
ii) Every time when the cycle is completed, the firm receives profit.

iii) On buying the existing loan, the lending company can assess the quality
of loans through a credit rating agency and thus, reducing the risks
considerably.

iv) Normally, lending blocks the funds of lender for a long-term whereas an
investment in securitized asset brings liquidity for the funds invested. So,
it is a rare case of win-win situation for both the borrower and investors.

Disadvantages:
i) The process of securitisation is very complicated and at times may be an
expensive source of long-term finance.
ii) It may hamper the ability of the business to raise funds in the future.
iii) While taking back the assets and closing of the Special Purpose Vehicle
(SPV), the costs could be substantially high.
iv) The company may lose direct control over the assets securitized, which
could reduce business value in the event of flotation.
While securitization as a concept was developed to help finance companies to
convert their loans into liquid assets, it is now extensively used in several
other business situations. By securitizing, the company sells the receivables
to the intermediary agency, which collects the money and distributes to the
holders of such securities. It is possible for companies producing
commodities, where the demand is predictable, to raise long-term resources
by securitizing their future receivables. The amount thus raised can be used to
strengthen long-term or permanent working capital needs of the firms or
invest in fixed assets to expand the capacity.

9.6.2 Angel Financing

A new start-up business can flourish only if it is backed by sufficient funds.
Companies finance their businesses using own capital and borrowed funds.
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There are individuals who invest in companies which are in their initial Sources of Finance

stages of development for equity ownership interest, known as Angel

investors. These investors mostly lookout for the quality, passion, and
integrity of those who are starting the business, market opportunity, clearly
thought-out business plan, interesting technology, intellectual property, etc.

9.6.3 Crowd Funding

In today’s time of social networking many new ways have emerged for
raising funds, and crowd funding is one of them. It is an internet-based
mechanism where start-ups looking for funds and the potential investors can
transact. It is a practice of raising funds using multiple websites from
multiple funders. This gives budding entrepreneurs an opportunity to raise
funds for their business and for promoting products and services. A company
desirous of raising funds needs to create its profile on the website giving
details about the company, its products or services, the amount that is being
raised, etc. Those who are interested in it donate funds usually in exchange of
reward. The reward may be in form of a discount on the product or service
being offered by the company or in the form of perks. The reward could also
be in the form of equity or share in profits of the company. In reward-based
campaign there is no burden on the company in terms of interest or principal
repayments.
The technological platforms do not operate as financial intermediaries and
hence are not involved in the investment process. The advantage of these
platforms is that it provides a wider investor community to access
opportunities of investing in start-ups with small amounts. It requires
entrepreneurs to publicly disclose their business ideas and strategy which
may harm start-up with innovative business models, as it could easily be
copied. Here crowd investors may decide based on investment decisions
made by others. Crowd investors have hardly any influence on the business
and can wait for longer periods for getting back the invested capital.

9.6.4 Small Business Credit Cards

Business credit cards are just like the normal credit cards that are available.
These cards are however provided to business owners, giving an easy access
to revolving credit with a set credit limit to make purchases and withdrawals.
It increases the purchasing power of the company, but interest is charged if
the payment is not made in the billing cycle. It is a convenient and easily
accessible source of short-term finance to meet the immediate needs of the
business, thereby increasing the company’s purchasing power. The
advantages and disadvantages of using this source of finance are:

Advantages:
i) New business owners, who do not possess a well-established credit
history, can also qualify for revolving line of credit with these cards. It is
convenient to get business card as compared to bank loan.
ii) The small business credit cards provide a financial cushion to the
owners. In case of delay in accounts receivable or sales are low, the cash
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Financing
Decisions deficit of the business could be met through these cards.
iii) Most of the business purchases from vendors, contractors and suppliers
are made online. These business credit cards help in making these online
transactions, which also provide rewards and cash back incentive to the
owners.
iv) By making repayments on time, business owners can build-up a positive
credit report for their company. It could help in qualifying for a loan at
considerably lower interest rate.
Disadvantages:
i) All the convenience and ease come with a price in the form of higher
interest rates, which could add up quickly if the repayments are not made
in full in each month.
ii) In most of the cases a personal liability agreement is made to repay debt.
Default in payment could lead to a negative credit report.
iii) There is threat of cards or card information being stolen by vendors,
contractors or those moving in the office premises. One needs to be
vigilant that employees using these cards do not use it for personal
purchases and take adequate precautions while making online
transactions to avoid these cards being hacked.
iv) The providers of business credit cards can reset the interest rates
depending on the past performance and management of account.

9.7 SUMMARY
In this unit, the different sources of funds, which can be used by the firms for
various requirements of the businesses, are discussed. These sources are
usually classified in different categories based on time, ownership, and
source of their generation. The advantages and disadvantages of various
sources of funds have also been discussed.

Capital market plays a very important role in the mobilization of funds for
Investment. The capital market has experienced metamorphic changes over
the last few years. The competition in the market has become so intense
necessitating the introduction of several kinds of securities. The corporates in
India mostly raise their funds through capital market by issuing equity shares,
preference shares, debentures, bonds and secured premium notes.

As discussed in the unit venture capital is most suitable for high-risk projects,
where venture capitalist is willing to put equity and assumes risk provided the
project has a scope for high return. The commercial paper, factoring, bill
discounting, etc., along with the prominent emerging sources through which
firms can raise funds have also been covered elaborately. Each method has
got its own distinctive features and depending upon the market conditions
and financing strategies the company may adopt different methods of
financing the business.

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9.8 KEY WORDS
Venture Capital: Venture capital is a form of equity financing where capital
is invested in exchange for equity, typically a minority stake, in a company
that looks poised for significant growth.

Factoring: It is a financial service covering the financing and collection of

accounts receivables in domestic as well as international trade.
Commercial Paper: Commercial paper is a short-term debt instrument issued
by companies to raise funds generally for a period up to one year. It is an
unsecured money market instrument in the form of a promissory note, which
is freely transferable by endorsement and delivery.

Public Deposits: Public deposits are deposits of money accepted by

companies in India from the public for specified period ranging between 3
months and 36 months. These deposits are accepted within the limit and
subject to terms prescribed under the Companies (Acceptance of Deposits)
Rule, 1975.

Leasing: A lease is a contract whereby the owner of an asset (the Lessor)

grants to another person (the Lessee) exclusive right to use the asset for an
agreed period of time, in return for the payment of a rent (called Lease
Rental).

9.9 SELF ASSESSMENT QUESTIONS

1. Critically examine equity capital as a source of raising finance.

2. As a manager of a company, if you need funds to manage the working

capital effectively which source you would prefer and why?
3. Discuss the advantages and disadvantages of using Debentures as a
source of raising funds.

4. How is lease finance different from that of equity or debt finance?

5. Explain how Asset Securitization is considered as a source of finance?

Discuss its advantages and disadvantages to the company.

6. Describe the kinds of Projects preferred by Venture Capitalist. What are

the advantages of using venture capital funds, to a business?

9.10 FURTHER READINGS

1. Chandra, Prasanna. 2019, Financial Management, Theory and Practice,
Mc Graw-Hill, New Delhi
2. Pandey. I.M., 2021, Financial Management, Pearson Education India,
New Delhi

217
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Decisions 3. Sheridan Titman, Arthur J. Keown, and John D. Martin, 2019, Financial
Management: Principles and Applications, Pearson Education India,
New Delhi.
4. M.Y. Khan. M. Y and Jain. P.K., 2018, Financial Management,
McGraw Hill Education, New Delhi
5. Eugene F. Brigham, Joel F. Huston, 2018, Fundamental of Financial
Management, Cengage Learning India, New Delhi.
6. Richard Brealey, Stewart Myres & Franklin Allen, 2019, Principles of
Corporate Finance, Mc Graw Hill, New Delhi.

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