UGMBCC10 – FINANCIAL MANAGEMENT

Financial Management
Paper Code: UGMBCC10
Unit IIIa: Sources of Finance
Introduction
Finance is the backbone of any business entity, intricately connected to its every operational aspect. Just as
blood circulation sustains bodily functions, disruptions in financial arrangements can bring operations to a
standstill. The process of allocating funds to different departments within a business is complex and demands
careful decision-making.
The amount of required finance varies based on the nature and circumstances of the business. However,
generally, finance requirements can be broadly categorized into two components: contractual obligations and
ownership obligations. Contractual obligations include liabilities like creditors, bills payable, and bank loans,
while ownership obligations consist of equity.
Once the funding needs are estimated, the next critical step is selecting the sources from which to obtain the
required funds. There are various options available to businesses, each with its own set of advantages and
disadvantages. The choice of funding source depends on several factors, including the cost of capital,
duration of investment, current financial needs, and the risk tolerance of the firm. The selection process
involves a comprehensive analysis of these factors to determine the most suitable financing option. For
instance, long-term funding may be preferred for capital-intensive projects, while short-term financing may
be suitable for meeting immediate operational expenses.
In this chapter, the focus is on exploring the major sources of financing for businesses across different time
horizons, including long-term, medium-term, and short-term funding options. Each financing source has its
unique characteristics and implications for the business. Understanding these sources and their relative
advantages and disadvantages is crucial for making informed financing decisions.
By examining the intricacies of each financing option, businesses can effectively manage their financial
requirements while optimizing their capital structure and minimizing financial risk. This comprehensive
understanding of financing sources is essential for ensuring the financial health and sustainability of the
business in the long run.
Long-term Finance
Long-term finance requirements typically involve investments in assets that have a longer lifespan and
contribute to the core operations and growth of a business. These assets include land, buildings, machinery,
equipment, and vehicles. Long-term financing is often used for projects with extended timelines, such as
infrastructure development, expansion of production facilities, or the acquisition of major equipment.
Examples of long-term finance requirements:
1. Purchase of Real Estate: A company may require long-term financing to acquire land or buildings
for setting up manufacturing plants, office spaces, or retail outlets.
2. Investment in Machinery and Equipment: Businesses often need to invest in machinery,
equipment, and technology to enhance production processes, increase efficiency, or introduce new
products.
3. Infrastructure Development: Infrastructure projects like constructing roads, bridges, airports, and
power plants require substantial long-term financing due to their large scale and extended
construction periods.
4. Research and Development (R&D): Companies engaged in innovation and product development
may seek long-term financing to fund research initiatives, develop new technologies, or create
innovative products.
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Short-term Finance
Short-term finance requirements, on the other hand, cater to the day-to-day operational needs and short-term
obligations of a business. These needs primarily involve managing working capital, which includes funding
inventory purchases, covering operational expenses, and meeting short-term liabilities such as salaries and
utility bills.
Examples of short-term finance requirements:
1. Inventory Financing: Businesses often require short-term financing to purchase raw materials,
components, or finished goods to maintain adequate inventory levels to meet customer demand.
2. Accounts Payable: Short-term financing may be used to manage accounts payable, ensuring timely
payment to suppliers and vendors while optimizing cash flow.
3. Operating Expenses: Funds are needed to cover day-to-day operating expenses such as rent, utilities,
salaries, and marketing costs.
4. Seasonal Financing: Seasonal businesses, like retail stores or agricultural enterprises, may require
short-term financing to manage fluctuations in cash flow during peak and off-peak seasons.
In summary, long-term finance addresses capital investments for the future growth and sustainability of a
business, while short-term finance caters to immediate operational needs and cash flow management.
SOURCES OF FINANCE
Sources of finance mean the ways for mobilizing various terms of finance to the industrial concern. Sources
of finance state that, how the companies are mobilizing finance for their requirements. The companies
belong to the existing or the new which need sum amount of finance to meet the long-term and short-term
requirements such as purchasing of fixed assets, construction of office building, purchase of raw materials
and day-to-day expenses.
Sources of finance may be classified under various categories according to the following important heads:
1. Based on the Period
Sources of Finance may be classified under various categories based on the period. Long-term
sources: Finance may be mobilized by long-term or short-term. When the finance mobilized with
large amount and the repayable over the period will
be more than five years, it may be considered as long-term sources. Share capital,
issue of debenture, long-term loans from financial institutions and commercial banks come under
this kind of source of finance. Long-term source of finance needs to meet the capital expenditure of
the firms such as purchase of fixed assets, land and buildings, etc.
Long-term sources of finance include:
⚫ Equity Shares
⚫ Preference Shares
⚫ Debenture
⚫ Long-term Loans
⚫ Fixed Deposits
Short-term sources: Apart from the long-term source of finance, firms can generate finance with
the help of short-term sources like loans and advances from commercial banks, moneylenders, etc.
Short-term source of finance needs to meet the operational expenditure of the business concern.

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Short-term source of finance include:

⚫ Bank Credit
⚫ Customer Advances
⚫ Trade Credit
⚫ Factoring
⚫ Public Deposits
⚫ Money Market Instruments
2. Based on Ownership
Sources of Finance may be classified under various categories based on the period:
An ownership source of finance include
⚫ Shares capital, earnings
⚫ Retained earnings
⚫ Surplus and Profits
Borrowed capital include
⚫ Debenture
⚫ Bonds
⚫ Public deposits
⚫ Loans from Bank and Financial Institutions.
3. Based on Sources of Generation
Sources of Finance may be classified into various categories based on the period.
Internal source of finance includes
⚫ Retained earnings
⚫ Depreciation funds
⚫ Surplus
External sources of finance may be include
⚫ Share capital
⚫ Debenture
⚫ Public deposits
⚫ Loans from Banks and Financial institutions
4. Based in Mode of Finance Security finance may be include
⚫ Shares capital
⚫ Debenture
Retained earnings may include
⚫ Retained earnings
⚫ Depreciation funds

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Loan finance may include

⚫ Long-term loans from Financial Institutions
⚫ Short-term loans from Commercial banks.
The above classifications are based on the nature and how the finance is mobilized from various
sources. But the above sources of finance can be divided into three major classifications:
⚫ Security Finance
⚫ Internal Finance
⚫ Loans Finance
Ownership Securities
The ownership securities also called as capital stock, is commonly called as shares. Shares are the most
Universal method of raising finance for the business concern. Ownership capital consists of the following
types of securities.
⚫ Equity Shares
⚫ Preference Shares
⚫ No par stock
⚫ Deferred Shares
EQUITY SHARES
Equity Shares also known as ordinary shares, which means, other than preference shares. Equity
shareholders are the real owners of the company. They have a control over the management of the
company. Equity shareholders are eligible to get dividend if the company earns profit. Equity share capital
cannot be redeemed during the lifetime of the company. The liability of the equity shareholders is the
value of unpaid value of shares.
Features of Equity Shares
Equity shares consist of the following important features:
1. Maturity of the shares: Equity shares have permanent nature of capital, which has no maturity
period. It cannot be redeemed during the lifetime of the company.
2. Residual claim on income: Equity shareholders have the right to get income left after paying
fixed rate of dividend to preference shareholder. The earnings or the income available to the
shareholders is equal to the profit after tax minus preference dividend.
3. Residual claims on assets: If the company wound up, the ordinary or equity shareholders have
the right to get the claims on assets. These rights are only available to the equity shareholders.
4. Right to control: Equity shareholders are the real owners of the company. Hence, they have
power to control the management of the company and they have power to take any decision
regarding the business operation.
5. Voting rights: Equity shareholders have voting rights in the meeting of the company with the
help of voting right power; they can change or remove any decision of the business concern.
Equity shareholders only have voting rights in the company meeting and also they can nominate
proxy to participate and vote in the meeting instead of the shareholder.
6. Pre-emptive right: Equity shareholder pre-emptive rights. The pre-emptive right is the legal right of
the existing shareholders. It is attested by the company in the first opportunity to purchase
additional equity shares in proportion to their current holding capacity.
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7. Limited liability: Equity shareholders are having only limited liability to the value of shares they
have purchased. If the shareholders are having fully paid-up shares, they have no liability. For
example: If the shareholder purchased 100 shares with the face value of Rs. 10 each. He paid only
Rs. 900. His liability is only Rs. 100.
Total number of shares 100 Face value of shares Rs. 10
Total value of shares 100 × 10 = 1,000
Paid- up value of shares ₹900
Unpaid value/liability ₹100
Liability of the shareholders is only unpaid value of the share (that is ₹100).
Advantages of Equity Shares
Equity shares are the most common and universally used shares to mobilize finance for the company. It
consists of the following advantages.
1. Permanent sources of finance: Equity share capital is belonging to long-term permanent nature
of sources of finance, hence, it can be used for long-term or fixed capital requirement of the
business concern.
2. Voting rights: Equity shareholders are the real owners of the company who have voting rights.
This type of advantage is available only to the equity shareholders.
3. No fixed dividend: Equity shares do not create any obligation to pay a fixed rate of dividend. If
the company earns profit, equity shareholders are eligible forprofit, they are eligible to get
dividend otherwise, and they cannot claim any dividend from the company.
4. Less cost of capital: Cost of capital is the major factor, which affects the value of the company.
If the company wants to increase the value of the company,
they have to use more share capital because, it consists of less cost of capital (Ke) while compared
to other sources of finance.
5. Retained earnings: When the company have more share capital, it will be suitable for retained
earnings which is the less cost sources of finance while compared to other sources of finance.
Disadvantages of Equity Shares
1. Irredeemable: Equity shares cannot be redeemed during the lifetime of the business concern. It
is the most dangerous thing of over capitalization.
2. Obstacles in management: Equity shareholder can put obstacles in management by manipulation
and organizing themselves. Because, they have power to contrast any decision which are against
the wealth of the shareholders.
3. Leads to speculation: Equity shares dealings in share market lead to secularism during prosperous
periods.
4. Limited income to investor: The Investors who desire to invest in safe securities with a fixed
income have no attraction for equity shares.
5. No trading on equity:When the company raises capital only with the help of equity, the company
cannot take the advantage of trading on equity.
PREFERENCE SHARES
The parts of corporate securities are called as preference shares. It is the shares, which have preferential
right to get dividend and get back the initial investment at the time of winding up of the company.
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Preference shareholders are eligible to get fixed rate of dividend and they do not have voting rights.
Preference shares may be classified into the following major types:
1. Cumulative preference shares: Cumulative preference shares have right to claim dividends for those
years which have no profits. If the company is unable to earn profit in any one or more years, C.P.
Shares are unable to get any dividend but they have right to get the comparative dividend for the
previous years if the company earned profit.
2. Non-cumulative preference shares: Non-cumulative preference shares have no right to enjoy the
above benefits. They are eligible to get only dividend if the company earns profit during the years.
Otherwise, they cannot claim any dividend.
3. Redeemable preference shares: When, the preference shares have a fixed maturity period it
becomes redeemable preference shares. It can be redeemable during the lifetime of the company. The
Company Act has provided certain restrictions on the return of the redeemable preference shares.
4. Irredeemable Preference Shares
Irredeemable preference shares can be redeemed only when the company goes for liquidator. There is
no fixed maturity period for such kind of preference shares.
5. Participating Preference Shares
Participating preference sharesholders have right to participate extra profits after distributing the
equity shareholders.
6. Non-Participating Preference Shares
Non-participating preference sharesholders are not having any right to participate extra profits
after distributing to the equity shareholders. Fixed rate of dividend is payable to the type of
shareholders.
7. Convertible Preference Shares
Convertible preference sharesholders have right to convert their holding into equity shares after a
specific period. The articles of association must authorize the right of conversion.
8. Non-convertible Preference Shares
There shares, cannot be converted into equity shares from preference shares.
Features of Preference Shares
The following are the important features of the preference shares:
1. Maturity period: Normally preference shares have no fixed maturity period except in the case
of redeemable preference shares. Preference shares can be redeemable only at the time of the
company liquidation.
2. Residual claims on income: Preferential sharesholders have a residual claim on income. Fixed rate
of dividend is payable to the preference shareholders.
3. Residual claims on assets: The first preference is given to the preference shareholders at the time
of liquidation. If any extra Assets are available that should be distributed to equity shareholder.
4. Control of Management: Preference shareholder does not have any voting rights. Hence, they
cannot have control over the management of the company.
Advantages of Preference Shares
Preference shares have the following important advantages.

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1. Fixed dividend: The dividend rate is fixed in the case of preference shares. It is called as fixed
income security because it provides a constant rate of income to the investors.
2. Cumulative dividends: Preference shares have another advantage which is called cumulative
dividends. If the company does not earn any profit in any previous years, it can be cumulative
with future period dividend.
3. Redemption: Preference Shares can be redeemable after a specific period except in the case of
irredeemable preference shares. There is a fixed maturity period for repayment of the initial
investment.
4. Participation: Participative preference sharesholders can participate in the surplus profit after
distribution to the equity shareholders.
5. Convertibility: Convertibility preference shares can be converted into equity shares when the
articles of association provide such conversion.
Disadvantages of Preference Shares
1. Expensive sources of finance: Preference shares have high expensive source of finance while
compared to equity shares.
2. No voting right: Generally preference sharesholders do not have any voting rights. Hence they
cannot have the control over the management of the company.
3. Fixed dividend only: Preference shares can get only fixed rate of dividend. They may not enjoy
more profits of the company.
4. Permanent burden: Cumulative preference shares become a permanent burden so far as the
payment of dividend is concerned. Because the company must pay the dividend for the
unprofitable periods also.
5. Taxation: In the taxation point of view, preference shares dividend is not a deductible expense
while calculating tax. But, interest is a deductible expense. Hence, it has disadvantage on the
tax deduction point of view.
CREDITORSHIP SECURITIES
INTERNAL FINANCE
A company can mobilize finance through external and internal sources. A new company may not raise
internal sources of finance and they can raise finance only external sources such as shares, debentures and
loans but an existing company can raise both internal and external sources of finance for their financial
requirements. Internal finance is also one of the important sources of finance and it consists of cost of
capital while compared to other sources of finance.
Internal source of finance may be broadly classified into two categories:
A. Depreciation Funds
B. Retained earnings
Depreciation Funds
Depreciation funds are the major part of internal sources of finance, which is used to meet the working
capital requirements of the business concern. Depreciation means decrease in the value of asset due to wear
and tear, lapse of time, obsolescence, exhaustion and accident. Generally depreciation is changed against
fixed assets of the company at fixed rate for every year. The purpose of depreciation is replacement of
the assets after the expired period. It is one kind of provision of fund, which is needed to reduce the tax
burden and overall profitability of the company.

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Retained Earnings
Retained earnings are another method of internal sources of finance. Actually is not a method of raising
finance, but it is called as accumulation of profits by a company for its expansion and diversification
activities.
Retained earnings are called under different names such as; self finance, inter finance, and plugging
back of profits. According to the Companies Act 1956 certain percentage, as prescribed by the central
government (not exceeding 10%) of the net profits after tax of a financial year have to be compulsorily
transferred to reserve by a company before declaring dividends for the year.
Under the retained earnings sources of finance, a part of the total profits is transferred to various
reserves such as general reserve, replacement fund, reserve for repairs and renewals, reserve funds and
secrete reserves, etc.
Advantages of Retained Earnings
Retained earnings consist of the following important advantages:
1. Useful for expansion and diversification: Retained earnings are most useful to expansion and
diversification of the business activities.
2. Economical sources of finance: Retained earnings are one of the least costly sources of finance
since it does not involve any floatation cost as in the case of raising of funds by issuing different
types of securities.
3. No fixed obligation: If the companies use equity finance they have to pay dividend and if the
companies use debt finance, they have to pay interest. But if the company uses retained earnings
as sources of finance, they need not pay any fixed obligation regarding the payment of dividend
or interest.
4. Flexible sources: Retained earnings allow the financial structure to remain completely flexible.
The company need not raise loans for further requirements, if it has retained earnings.
5. Increase the share value: When the company uses the retained earnings as the sources of finance
for their financial requirements, the cost of capital is very cheaper than the other sources of finance;
Hence the value of the share will increase.
6. Avoid excessive tax: Retained earnings provide opportunities for evasion of excessive tax in a
company when it has small number of shareholders.
7. Increase earning capacity: Retained earnings consist of least cost of capital and also it is most
suitable to those companies which go for diversification and expansion.
Disadvantages of Retained Earnings
Retained earnings also have certain disadvantages:
1. Misuses: The management by manipulating the value of the shares in the stock market can misuse
the retained earnings.
2. Leads to monopolies: Excessive use of retained earnings leads to monopolistic attitude of the
company.
3. Over capitalization: Retained earnings lead to over capitalization, because if the company uses
more and more retained earnings, it leads to insufficient source of finance.
4. Tax evasion: Retained earnings lead to tax evasion. Since, the company reduces tax burden
through the retained earnings.
5. Dissatisfaction: If the company uses retained earnings as sources of finance, the shareholder can’t
get more dividends. So, the shareholder does not like to use the retained earnings as source of
finance in all situations.

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