Module II

Sources of Finance
Need for long term finance,
Evaluation of sources of long term finance,
Equity shares,
Preference shares,
Debentures,
Public deposits,
Retained earnings,
Long term borrowings from financial institutions,
Venture capital financing,
Lease and Hire purchase finance,
Need and sources of short term finance. (Only
Theory)
Capital Requirement of a business
 Capital required by a business is of two
types:

 I. Fixed Capital (For long term-More than 1

year)
 II. Working Capital(For short term-less than 1

year)
Need for Long Term Finance
 To create Production facilities,
 To invest in fixed assets (Plant, machinery,

land building, furniture)

 To Under take expansion
 To go in for diversification
 To under take Modernization., etc.
Evaluation of sources of long term finance,

Sources of long term finance includes:

 Equity shares,

 Preference shares,
 Debentures,

 Public deposits,
 Retained earnings/ Ploughing back of profits

 Long term borrowings from financial

institutions,
 Venture capital financing,
 Lease and Hire purchase finance,
Evaluation of Equity Shares

 Equity shares are also called as ordinary

shares, common shares, risk shares,
ownership shares etc.
 Equity shares represent the owners capital in

the capital and the holders of equity shares

are the real owners of the company. They
have control over the company. They receive
dividends.
Evaluation of Equity Shares Nature of Equity shares:

 Permanent source of capital.

 Right over income of the company.
 Fluctuating dividends.
 Right over the assets of the company.
 Right to control/voting rights.
 Right to “Rights issue of shares”.
 Right to limited liability.
Evaluation of Equity Shares:
Merits of Equity Shares

 Permanent source of capital,

 No obligation to give fixed dividends,
 No charge on the assets of the company,
 Equity share holders are the real owners of

the company,
 Their dividends depends upon the
performance of the company. They get more
dividends when the company performs better.
Evaluation of Equity Shares:
De-Merits of Equity Shares

 Only from equity sharers companies cannot

leverage,
 Equity capital cannot be redeemed during the

life time of the company (repaid),

 Equity share results in dilution of control over

the business,
 Equity cost is high, particularly when the

company is earning huge profits,

 Investing in equity shares is risky. That is
why they are also called as risk shares
Evaluation of Preference Shares,

 Preference shares are the shares which have

preference over equity shares in terms of:

 1. Payment of dividends,
 2. Repayment of capital at the time of

winding up of the company.

Evaluation of Preference Shares: Nature of Preference Shares

 Not a permanent source of capital (generally

redeemed after few years)
 Right to receive fixed rate of dividends before
paying to equity shares,
 Right to receive capital back before paying to
equity shares,
 No control over the company. They do not have
voting rights over the day to day management of
the company,
 It is a high breed financial instrument, as it has
the features of equity and debt instruments.
Evaluation of Preference Shares: Merits of Preference Shares

 Fixed rate of dividends in times of more

profits. It is less costly to the company,
 Long term capital to the company,
 Option to the company to redeem the

preference shares,
 Preferential rights over equity shares in terms

of dividends and repayment of capital,

 No voting rights, hence no loss of control to

the company.
Evaluation of Preference Shares: De-Merits of Preference Shares

 It is expensive than debt capital. Dividends on

preference shares are more than the interest on
debentures,
 Fixed rate of dividend. Dividends gets accumulated
till they are paid (Cumulative preference shares),
 Preference shares do not give any tax benefit to the
company,
 Preference share holders do not carry any voting
rights,
 Preference share holders do not have any charge over
assets of the company like the debentures.
Evaluation of Debentures/Bonds
 Debenture is an instrument issued by the
company under its common seal,
acknowledging its debt, with a promise to
repay the debt after a fixed period and in the
mean time, to pay a fixed rate of interest at
periodical intervals.
Evaluation of Debentures/ Bonds
Nature of debentures
 They have a fixed maturity- They are repaid
after a particular period,
 Interest paid on debentures have a charge on
the profits of the company,
 Debenture have charge on the assets of the
company (secured debentures),
 Debenture holders are not the owners of the
compnay. They are the creditors of the
company.
 Debenture the repaid before the share capital.
Evaluation of Debentures/ Bonds
Merits of debentures
 They are a source of long term capital to the
company,
 Rate of interest on debentures is less the

dividends on shares,
 Interest paid on debentures will result in tax

benefits to the company,

 Debenture holders have a charge on the

profits. They receive interest even when

there are no profits.
 Leveraging is possible with debentures.
Evaluation of Debentures/ Bonds
De-Merits of debentures
 The company has to pay interest even when
the company is going under loss,
 Creating charge over the assets, is not in the

best interest of the company,

 Leveraging increases the risk profile of the

business,
 Companies with unstable returns, should not

go for debenture capital,

 No voting rights to the debenture holders.

They are just the creditors of the company,

Evaluation of Public Deposits,

 Accepting deposits from the general public

by a company is called public deposit.
 A company can accept deposits from the

public to finance its medium term

requirements of funds.
 This source has become very popular off late

because companies offer higher interest than

the interest offered by banks.
Evaluation of Public Deposits: Nature of public deposits

 Total public deposits cannot exceed 25 per

cent of the paid up capital and free reserves
of the company.
 The period of deposit cannot be more than

36 months or 3 years,
 It is an uncertain source of financing,
 The accepting company is required to pay

fixed rate of interest to the deposit holders,

 There are legal restrictions on the acceptance

and renewal of public deposits.

Evaluation of Public Deposits: Merits of public Deposits

 Acquisition of finance through public deposits is

very easy.
 Interest paid on public deposits is tax deductible
expenditure.
 Administrative cost of issuing a public deposit is
lower than the cost involved in issuing shares
and debentures.
 Since the rate of interest paid on a public deposit
is fixed, it helps the company play trading on
equity.
 It does not dilute the control of shareholders.
Evaluation of Public Deposits: Merits of public Deposits

 They are uncertain and unrealistic form of

financing,
 Public deposits are available for period not

more than 3 years,

 The amount of public deposit cannot exceed

25% of equity share capital and free reserves,

 The management of companies may misuse

the deposit as these deposits are not secured.

Evaluation of Retained Earnings
 The portion of profits not distributed among
the shareholders but retained and used in
business is called retained earnings.
 It is also referred to as ploughing back of

profits.
 This is one of the important sources of

internal financing used for fixed as well as

working capital.
 Retained earnings increase the value of

shareholders
 Evaluation of Retained Earnings: Nature of Retained
earnings

 Retained earnings have no cost to the company,

 There is no floatation Cost. Expenses are not
incurred on retained earnings, as they are
generated internally,
 Use of retained earnings will not result in the
dilution of control of existing shareholders,
 Use of retained earnings does not require
compliance of any legal formalities. It just
requires a resolution to be passed in the annual
general meeting of the company.
 Evaluation of Retained Earnings: Merits of Retained
Earnings

 The use of retained earnings does not involve any

acquisition cost. The company has no obligation to
pay anything in respect of retained earnings.
 Retained earnings strengthen the financial position of
a business and thereby give financial stability to the
business.
 Shareholders may get stable dividend even if the
company does not earn enough profit.
 Retained earnings strengthen the financial position of
a company and appreciate the capital which
ultimately increases the market value of shares.
Evaluation of Retained Earnings:
Demerits of Retained Earnings
 If the purpose for utilization of retained earnings
is not clearly stated, it may lead to careless
spending of funds.
 Conservative dividend policy leads to huge
accumulation of retained earnings leading to
over-capitalization.
 Retained earnings do not allow shareholders to
enjoy full benefit of the actual earnings of the
company. This creates not only dissatisfaction
among the shareholders but also adversely
affect the market value of shares.
Long term borrowings from financial institutions

Huge sums of Money borrowed from long

term financial institutions like the IFC, SFC,
SIDBI etc for longer periods at less rate of
interest is called as Long term borrowings
from financial institutions or term
borrowings.
Long term borrowings from financial institutions: Nature

 Long term financial institutions (LTFI) like IFC,

SFC, SIDBI provide long-term finance, which
are not provided by commercial banks;
 LTFI provide services like financial,
managerial and technical in addition to
provision of loans,
 The funds are made available even during

periods of depression, when other sources of

finance are not available.
Long term borrowings from financial institutions: Merits

 Financial institutions provide long-term finance, which are not

provided by commercial banks,
 Besides providing funds, many of these institutions provide
financial, managerial, technical and consultancy to business
firms,
 Obtaining loan from financial institutions increases the
goodwill of the borrowing company in the capital market.
Consequently, such a company can raise funds easily from
other sources as well,
 As repayment of loan can be made in easy installments, it does
not prove to be much of a burden on the business;
 The funds are made available even during periods of
depression, when other sources of finance are not available.
Long term borrowings from financial institutions: Demerits

 Financial institutions follow rigid criteria for grant of

loans. Too many formalities make the procedure time
consuming and expensive,
 Certain restrictions such as restriction on dividend
payment are imposed on the powers of the borrowing
company by the financial institutions,
 Financial institutions may have their nominees on the
Board of Directors of the borrowing company thereby
restricting the powers of the company,
 Many deserving concerns may fail to get assistance
for want of security and other conditions laid down
by these institutions.
Venture Capital Financing
 Venture capital financing is a source of long
term financing by venture capitalists who are
experts in the area of business. They invest
to hold a percentage of equity and extend all
possible support in day to day management
of the business.
Venture Capital Financing: Nature of
VCF
 It is not a loan scheme. It works on the principle of
equity and profit sharing.
 Venture capitalists are experts in the are of business
in which they have invested.
 They extend their support in day to day management.
 VC firms expect more ROI than industry expectation.
 VC firms expect that the major decisions of the
business are known to them.
 They influence decision making process.
 They release funds in installments.
Venture Capital Financing: Merits of
VCF
 Since VC funding is not a loan scheme, there is no
repayment schedule, Business don’t have to repay as
debt.
 Most of the venture capitalists are experts in their areas.
Their expertise will protect the business from incurring
losses.
 Since VCs will hold a percentage of equity, they will also
extend their support in day to day management,
 As they are obligated to make profit from their investment
they often provide consultancy to the business,
 VC firms are very easy to locate as they are as they
documented in business directories.
Venture Capital Financing:
Demerits of VCF: Demeits
 VC firms expect more ROI than industry expectation.
 Usually, VC firms add their members in the business. it can create
internal problems.
 VC firm will require to be informed of any major decision of the
company. Business secrecy cannot be maintained.
 Though they generally treat information confidentially, VC firms
usually refuse to sign a non-disclosure agreement.
 Venture capitalists take too long to decide whether to invest in the
business or not.
 Most VC firms do not release all the needed funds. Rather, they
usually release funds in stages with an eye on the expansion of the
business.
 Usually, VC firms want to close the deal and get their investment
back within three to five years. If the business plan contemplates a
longer timetable, then VC funding may not be suitable.
Lease Financing
 A lease can be defined as an arrangement
between the lessor (owner of the asset) and
the lessee (user of the asset) whereby the
lessor purchases an asset for the lessee and
allows him to use it in exchange for
periodical payments called lease rentals.
Lease Financing: Nature
 Leasing is a contract between the lessor and the
lessee
 Lease is an off-balance sheet debt and doesn’t
appear on company’s balance sheet.
 Lease expenses remain same over the lease
tenor.
 It involves lower initial cost and lower Capital
Expenditure requirements.
 No Risk of Obsolescence
 Lease rentals reduces profits and dividends to
share holders.
Lease Financing: Merits
 Cash outflow or payments related to leasing are spread
out over several years.
 The ownership of the asset still lies with the lessor
whereas the lessee just pays the rental expense.
 Given that a company chooses to lease over investing in
an asset by purchasing, it releases capital for the
business to fund its other capital needs or to save
money for a better capital investment decision.
 Leasing expense or lease payments are considered as
operating expenses, and hence, are tax deductible.
Lease Financing: Merits
 The lease itself is treated differently from debt. Leasing
is classified as an off-balance sheet debt and doesn’t
appear on company’s balance sheet.
 Lease expenses usually remain constant for over the
asset’s life or lease tenor.
 Leasing is an ideal option for a newly set-up business
given that it means lower initial cost and lower Capital
Expenditure requirements.
 No Risk of Obsolescence.
 At the end of the leasing period, the lessee holds the
right to buy the property and terminate the leasing
contract, this providing flexibility to business.
Lease Financing: De-Merits
 To enter into a lease agreement is a complex
process and requires thorough documentation
and proper examination of an asset being
leased.
 Lease payments are treated as expenses rather
than as an investment towards an asset.
 Business cannot benefit from any appreciation
in the value of the asset.
 The long-term lease agreement also remains a
burden on the business.
Lease Financing: De-Merits
 Given that lease expenses reduce the net
income without any appreciation in value, it
means limited returns or reduced returns for an
equity shareholder.
 Although lease doesn’t appear on the balance
sheet of a company, investors still consider
long-term lease as debt and adjust their
valuation of a business to include leases.
 Given that investors treat long-term leases as
debt, it might become difficult for a business to
tap capital markets and raise further loans.
Hire Purchase Financing:
 Hire purchase is a method of financing of the
fixed asset to be purchased on a future date.
 Under this method of financing, the purchase

price is paid in installments.

 Ownership of the asset is transferred after

the payment of the last installment.

Hire Purchase Financing: Nature
 The hire purchaser becomes the owner of the
asset after paying the last installment.
 Every installment is treated as hire charge for

using the asset.

 Hire purchaser can use the asset right after

making the agreement with the hire vendor.

 The hire vendor has the right to repossess

the asset in case hire purchaser fail to make

prompt payment of installment.
Hire Purchase Financing: Merits
 Financing of an asset through hire purchase
is very easy.
 Hire purchaser becomes the owner of the

asset in future.
 Hire purchaser gets the benefit of
depreciation on asset hired by him/her.
 Hire purchasers also enjoy the tax benefit on

the interest payable by them.

Hire Purchase Financing:
De-Merits
 Ownership of asset is transferred only after
the payment of the last installment.
 The magnitude of funds involved in hire

purchase are small and only small types of

assets like office equipment’s, automobiles,
etc., are purchased through it.
 The cost of financing through hire purchase

is very high. It includes the principal

repayment and interest
Need and Sources of Short Term Finance

 Why short Term Finance:

 It facilitates the smooth running of business

operations by meeting day to day financial
requirements.
 It enables firms to hold stock of raw materials
and finished product.
 With the availability of short-term finance goods
can be sold on credit.
 It is necessary to increase the volume of
production at a short notice.
Sources of Short Term Finance

 Trade credit
 Bank credit (Loans & advances, Cash credit,

Overdraft, Discounting of bills)

 Customers’ advances
 Installment credit
 Loans from co-operatives
Sources of Short Term Finance :Trade Credit

 Trade credit refers to credit granted to

manufactures and traders by the suppliers of raw
material, finished goods, components, etc
 Usually business enterprises buy supplies on a 30
to 90 days credit.
 This means that the goods are delivered but
payments are not made until the expiry of period
of credit.
 This type of credit facilitates purchases without
making immediate payment.
 This is quite a popular source of finance.
Sources of Short Term Finance : Bank Credit

(i) Loans:
 When certain amount is advanced by a bank repayable
after a specified period, it is known as bank loan. Such
advance is credited to a separate loan account and the
borrower has to pay interest on the whole amount of
loan.
 (ii) Cash Credit:
It is an arrangement whereby banks allow the borrower
to withdraw money upto a specified limit. This limit is
known as cash credit limit. Initially this limit is granted
for one year. Interest is charged only on the amount
actually withdrawn and not on the amount of entire limit.
Sources of Short Term Finance : Bank Credit

(iii) Overdraft
 When a bank allows its depositors or account holders to
withdraw money in excess of the balance in his account up-to a
specified limit, it is known as overdraft facility.
 Current account holder is given this facility. Rate of interest in
case of overdraft is less than the rate charged under cash credit.

 (iv) Discounting of Bill

Banks also advance money by discounting bills of exchange,
promissory notes. When these documents are presented before
the bank for discounting, banks credit the amount to customer's
account after deducting discount. The amount of discount is
equal to the amount of interest for the period of bill.
Sources of Short Term Finance : Customers’ Advances

 Sometimes businessmen insist on their

customers to make some advance payment.
 It is generally asked when the value of order

is quite large or things ordered are very

costly.
 Customers’ advance represents a part of the

payment towards price on the product which

will be delivered at a later date.
Sources of Short Term Finance :
Instalment credit

 Installment credit is now-a-days a popular

source of finance for consumer goods like
television, refrigerators as well as for
industrial goods.
 Only a small amount of money is paid at the

time of delivery of such articles. The balance

is paid in a number of installments. The
supplier charges interest for extending credit.
The amount of interest is included while
deciding on the amount of installment.
Sources of Short Term Finance : Loans from Co-operative Banks

 Co-operative banks are a good source to

procure short-term finance. Such banks have
been established at local, district and state
levels. District Cooperative Banks are the
federation of primary credit societies. The
State Cooperative Bank finances and controls
the District Cooperative Banks in the state.
They are also governed by Reserve Bank of
India regulations.