SOURCES OF FINANCE

INTRODUCTION
• There are various sources of finance such as equity, debt,
debentures, retained earnings, term loans, working
capital loans, letter of credit, euro issue, venture funding
etc. These sources are useful in different situations. They
are classified based on time period, ownership and
control, and their source of generation.
• Sources of finance are the most explored area especially
for the entrepreneurs about to start a new business. It is
perhaps the toughest part of all the efforts. There are
various sources of finance classified based on time
period, ownership and control, and source of generation
of finance.
 ACCORDING TO TIME-PERIOD:
LONG TERM SOURCES OF MEDIUM TERM SOURCES SHORT TERM SOURCES OF
FINANCE OF FINANCE FINANCE
Long-term financing means Medium term financing Short term financing
capital requirements for a means financing for a means financing for a
period of more than 5 period of 3 to 5 years. period of less than 1 year.
years to 10, 15, 20 years or Medium term financing is Need for short term
maybe more depending on used generally for two finance arises to finance
other factors. Capital reasons. One, when long- the current assets of a
expenditures in fixed assets term capital is not available business like an inventory
like plant and machinery, for the time being and of raw material and
land and building etc of a second, when deferred finished goods, debtors,
business are funded using revenue expenditures like minimum cash and bank
long-term sources of advertisements are made balance etc. Short term
finance. Part of working which are to be written off financing is also named as
capital which permanently over a period of 3 to 5 working capital financing.
stays with the business is years.
also financed with long-
term sources of finance.
 ACCORDING TO TIME-PERIOD:

Long term financing Medium term financing Short term finances are
sources can be in form of sources can in the form of available in the form of:
any of them: one of them: 1. Trade Credit
1. Share Capital or Equity 1. Preference Capital or 2. Short Term Loans like
Shares Preference Shares Working Capital Loans
2. Preference Capital or 2. Debenture / Bonds from Commercial Banks
Preference Shares 3. Medium Term Loans 3. Fixed Deposits for a
3. Retained Earnings or from period of 1 year or less
Internal Accruals 1. Financial Institutes 4. Advances received from
4. Debenture / Bonds 2. Government, and customers
5. Term Loans from 3. Commercial Banks 5. Creditors
Financial Institutes, 4. Lease Finance 6. Payables
Government, and 5. Hire Purchase Finance 7. Factoring Services
Commercial Banks 8. Bill Discounting etc.
6. Venture Funding
7. Asset Securitization
8. International Financing
by way of Euro Issue,
Foreign Currency Loans,
ADR, GDR etc.
 ACCORDING TO OWNERSHIP AND CONTROL:
OWNED CAPITAL
Owned capital is also referred as equity capital. It is sourced from promoters of the company or from
the general public by issuing new equity shares. Business is started by the promoters by bringing
in the required capital for a startup. Owners capital is sourced from following sources:
• Equity Capital
• Preference Capital
• Retained Earnings
• Convertible Debentures
• Venture Fund or Private Equity
Further, when the business grows and internal accruals like profits of the company are not enough
to satisfy financing requirements, the promoters have a choice of selecting ownership capital or
non-ownership capital. This decision is up to the promoters. Still, to discuss, certain advantages
of equity capital are as follows:
It is a long term capital which means it stays permanently with the business.
There is no burden of paying interest or installments like borrowed capital. So, the risk of bankruptcy
also reduces. Businesses in infancy stages prefer equity capital for this reason.
BORROWED CAPITAL
Borrowed capital is the capital arranged from outside sources. These
include the following:
• Financial institutions,
• Commercial banks or
• The general public in case of debentures.
In this type of capital, the borrower has a charge on the assets of the
business which means the borrower would be paid by selling the
assets in case of liquidation. Another feature of borrowed capital
is regular payment of fixed interest and repayment of capital.
Certain advantages of borrowing capital are as follows:
There is no dilution in ownership and control of business.
The cost of borrowed funds is low since it is a deductible expense for
taxation purpose which ends up saving on taxes for the company.
It gives the business a leverage benefit.
ACCORDING TO SOURCE OF GENERATION:

INTERNAL SOURCES
Internal source of capital is the capital which is generated
internally from the business. Internal sources are as follows:
• Retained profits
• Reduction or controlling of working capital
• Sale of assets etc.
The internal source has the same characteristics of owned capital.
The best part of the internal sourcing of capital is that the
business grows by itself and does not depend on outside
parties. Disadvantages of both equity capital and debt capital
are not present in this form of financing. Neither ownership is
diluted nor fixed obligation / bankruptcy risk arises.
EXTERNAL SOURCES
An external source of finance is the capital which is generated
from outside the business. Apart from the internal sources
finance, all the sources are external sources of capital.
Deciding the right source of finance is a crucial business decision
taken by top-level finance managers. The wrong source of
finance increases the cost of funds which in turn would have a
direct impact on the feasibility of project under concern.
Improper match of the type of capital with business
requirements may go against the smooth functioning of the
business. For instance, if fixed assets, which derive benefits
after 2 years, are financed through short-term finances will
create cash flow mismatch after one year and the manager
will again have to look for finances and pay the fee for raising
capital again.
 SHORT TERM SOURCES

Indigenous Bankers:
Private money-leaders and other country bankers used to be the only sources of finance prior to the
establishment of commercial banks. They used to charge very high rates of interest and
exploited the customers to the largest extent possible. Now-a-days with the development of
commercial banks they have lost their monopoly. But even today some business houses have to
depend upon indigenous bankers for obtaining loans to meet their working capital
requirements.
Trade Credit refers to the credit that a buyer obtains from the suppliers of goods and services.
Payment is required to be made within a specified period. Suppliers sometimes offer cash
discount to buyers for making prompt payment. Buyer should calculate the cost of foregoing
cash discount to decide whether or not cash discount should be availed. A buyer should also
consider the implicit costs of trade credit, and particularly, that of stretching accounts payable.
These implicit costs may be built into the prices of goods and services. Buyer can negotiate for
lower prices for making payment in cash.
Commercial Banks: Commercial banks are the most important source of short-term capital. The
major portion of working capital loans are provided by commercial banks. They provide a wide
variety of loans tailored to meet the specific requirements of a concern.
The different forms in which the banks normally provide loans and advances are as follows:
(a) Loans
(b) Cash Credits
(c) Overdrafts, and
(d) Purchasing and discounting of bills.
Commercial Paper:
• Commercial paper represents unsecured promissory notes
issued by firms to raise short-term funds. It is an important
money market instrument in advanced countries like U.S.A. In
India, the Reserve Bank of India introduced commercial paper
in the Indian money market on the recommendations of the
Working Group on Money Market (Vaghul Committee).
• But only large companies enjoying high credit rating and sound
financial health can issue commercial paper to raise short-term
funds. The Reserve Bank of India has laid down a number of
conditions of determine eligibility of a company for the issue of
commercial paper.
• Only a company which is listed on the stock exchange has a net
worth of at least Rs. 10 crores and a maximum permissible
bank finance of Rs. 25 crores can issue commercial paper not
exceeding 30 per cent of its working capital limit.
Installment Credit:
This is another method by which the assets are purchased and the possession of goods is taken
immediately but the payment is made in Installment over a pre-determined period of time.
Generally, interest is charged on the unpaid price or it may be adjusted in the price.
But, in any case, it provides funds for sometimes and is used as a source of short-term working
capital by many business houses which have difficult funds position.
Advances:
Some business houses get advances from their customers and agents against orders and this
source is a short-term source of finance for them. It is a cheap source of finance and in order
to minimize their investment in working capital, some firms having long production cycle,
especially the firms manufacturing industrial products prefer to take advance from their
customers.
Factoring:
Another method of raising short-term finance is through account receivable credit offered by
commercial banks and factors. A commercial bank may provide finance by discounting the bills
or invoices of its customers. Thus, a firm gets immediate payment for sales made on credit.
A factor is a financial institution which offers services relating to management and financing of
debts arising out of credit sales. Factoring is becoming popular all over the world on account
of various services offered by the institutions engaged in it.
Factors render services varying from bill discounting facilities offered by commercial banks to a
total take-over of administration of credit sales including maintenance of sales ledger,
collection of accounts receivables, credit control and protection from bad debts, provision of
finance and rendering of advisory services to their clients.
Accrued Expenses:
Accrued expenses are the expenses which have been incurred but not yet due and hence not
yet paid also. These simply represent a liability that a firm has to pay for the services
already received by it. The most important items of accruals are wages and salaries,
interest, and taxes.
Wages and salaries are usually paid on monthly, fortnightly or weekly basis for the services
already rendered by employees. The longer the payment- period, the greater is the
amount liability towards employees or the funds provided by them.
Deferred Incomes:
Deferred incomes are incomes received in advance before supplying goods or services. They
represent funds received by a firm for which it has to supply goods or services in future.
These funds increase the liquidity of a firm and constitute an important source of short-
term finance.
However, firms having great demand for its products and services, and those having good
reputation in the market can demand deferred incomes.
Letter of Credit:
A letter of credit popularly known as L/C is an undertaking by a bank to honor the obligation
of its customer up to a specified amount, should the customer fail to do so. It helps its
customers to obtain credit from suppliers because it ensures that there is no risk of non-
payment.
L/C is simply a guarantee by the bank to the suppliers that their bills up to a specified amount
would be honored. In case the customer fails to pay the amount, on the due date, to its
suppliers, the bank assumes the liabilities of its customer for the purchases made under
the letter of credit arrangement.
Public Deposits:
Acceptance of fixed deposits from the public by all type of manufacturing and non-bank
financial companies in the private sector has been a unique feature of Indian financial
system. The importance of such deposits in financing of Indian industries was recognized
as early as in 1931 by the Indian Central Banking Enquiry Committee.
It has been most common in the financing of cotton textile industry in Bombay and
Ahmedabad, but in the recent years many companies have accepted deposits from the
public to finance their working capital requirements.
The manifold increase in demand for public deposits from the corporate sector in India has
been on account of restrictive credit policy of the Govt. of India and a substantial credit
gap existing in the market.
As a result, companies have been accepting deposits directly from the public by offering
higher rates of interest as compared to banks and post offices to meet their requirements
of funds. But even by offering higher rates of interest to the investors, the cost of funds
raised through public deposits to the companies has been lower than the minimum rate
of interest on bank advances.
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 (s)
which will be delivered at a later date. Customers generally agree to make advances when
such goods are not easily available in the market or there is an urgent need of goods. A
firm can meet its short-term requirements with the help of customers’ advances.
 Long term sources of finance:

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
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.
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.
CREDITORSHIP SECURITIES
Creditorship Securities also known as debt finance which means the finance is mobilized from the creditors.
Debenture and Bonds are the two major parts of the Creditorship Securities.
Debentures
A Debenture is a document issued by the company. It is a certificate issued by the company under its seal
acknowledging a debt. According to the Companies Act 1956, “debenture includes debenture stock,
bonds and any other securities of a company whether constituting a charge of the assets of the company
or not.”

Types of Debentures
1. Unsecured debentures: Unsecured debentures are not given any security on assets of the company. It is
also called simple or naked debentures. This type of debentures are treaded as unsecured creditors at the
time of winding up of the company.
2. Secured debentures: Secured debentures are given security on assets of the company. It is also called as
mortgaged debentures because these debentures are given against any mortgage of the assets of the
company.
3. Redeemable debentures: These debentures are to be redeemed on the expiry of a certain period. The
interest is paid periodically and the initial investment is returned after the fixed maturity period.
4. Irredeemable debentures: These kind of debentures cannot be redeemable during the life time of the
business concern.
5. Convertible debentures: Convertible debentures are the debentures whose holders have the option to get
them converted wholly or partly into shares. These debentures are usually converted into equity shares.
Conversion of the debentures may be:
Non-convertible debentures
Fully convertible debentures
Partly convertible debentures
Features of Debentures
1. Maturity period: Debentures consist of long-term fixed maturity period.
Normally, debentures consist of 10–20 years maturity period and are repayable
with the principle investment at the end of the maturity period.
2. Residual claims in income: Debenture holders are eligible to get fixed rate of
interest at every end of the accounting period. Debenture holders have priority
of claim in income of the company over equity and preference shareholders.
3. Residual claims on asset: Debenture holders have priority of claims on Assets of
the company over equity and preference shareholders. The Debenture holders
may have either specific change on the Assets or floating change of the assets of
the company. Specific change of Debenture holders are treated as secured
creditors and floating change of Debenture holders are treated as unsecured
creditors.
4. No voting rights: Debenture holders are considered as creditors of the company.
Hence they have no voting rights. Debenture holders cannot have the control
over the performance of the business concern.
5. Fixed rate of interest: Debentures yield fixed rate of interest till the maturity
period. Hence the business will not affect the yield of the debenture.
Term Loans are loans for more than a year
maturity. Generally, in India, they are
available for a period of 6 to 10 years. In some
cases, the maturity could be as long as 25
years. Interest on term loans is tax deductible.
Mostly, term loans are secured through an
equitable mortgage on immovable assets. To
protect their interest, lending institutions
impose a number of restrictions on the
borrowing firm.
INTERNAL FINANCE
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.
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. 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:
• 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.
• 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.
• 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.
• 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.
• Participating Preference Shares
• Participating preference shareholders have right to participate extra profits after distributing the equity
shareholders.
• Non-Participating Preference Shares
• Non-participating preference shareholders 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.
• Convertible Preference Shares
• Convertible preference shareholders have right to convert their holding into equity shares after a specific
period. The articles of association must authorize the right of conversion.
• 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 shareholders 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.