Sources of Finance

Finance is the provision of money at the time when it is required. Adequate firance is
inevitable one for every business organisation irrespective of size, nature and scale of
operation. Hence, it is rightly said that finance is the life blood of every business
organisation. Every business organisation needs finance mainly for two purposes
i. to facilitate production facilities, and
ii. to carry out day-to-day operations
Finance needed to support production facilities is termed as long term finance of fired capital
and finance needed for day to day operations are referred as the mo finance or working
capital.
Long Term Sources
Long term sources refer to raising of finance normally for a period beyond one year It is
composed of raising of funds through shares, debentures, bonds, retained earnings.
financial institutions, sale of fixed assets etc. The financing through shares, debentures and
bonds is known as security financing
I.Issue of Shares
Financing through shares is the important source used by companies for raising capital.
Equity shares and preference shares are the different types of shares issued by the
companies
A.Financing through Equity Shares
Equity shares are the foundation of the financial structure of the company. They are also
known as ordinary shares or common shares representing ownership capital Equity shares
are those shares which have no preferential right for getting dividend and repayment of
capital at the time of winding up.
Characteristics of Equity Shares
1.Maturity: Equity shares provide permanent capital to the company and cannot be
redeemed during the lifetime of the company.
2.Claim on income: Equity shareholders have a residual claim on the income of the
company. They have a claim on income left after paying dividend to preference
shareholders.
3.Claim on assets: Equity shareholders have a residual claim on ownership of company's
assets.
4.Right to control or voting right: Equity shareholders are the real owners of the company.
They have voting right in the meeting of the company and have a control over its working.
5.Pre-emptive right: When a company makes subsequent issue of capital, it must be first
offered to the existing shareholders.
6.Limited liability: Limited liability means that the liability of a shareholder is limited to the
extent of the face value of shares
Advantages of Equity Shares
1.Equity share capital is a permanent source of fund.
2.Equity shares do not create obligation to pay a fixed rate of dividend
3.Fresh issue of equity shares provides flexibility to the capital structure as funds are
obtained without creating any charge over the assets of the company
4.By mawing right shares, it is possible to raise additional funds without diluting the control of
existing shareholders.
5.Equity shareholders have voting rights.
Disadvantages of Equity Shares
1.Cost of equity capital is the highest of all sources.
2.Payment of dividend will attract Corporate Dividend Tax which is an additional burden to
the company.
3.Additional issue of equity shares will reduce earning per share.
4.If only equity shares are issued, the company cannot take the advantage of trading on
equity.
5.There is no assurance on dividend on equity shares.
B. Preference Shares
Preference shares form an important source for raising long term capital. Preference shares
are those shares which have preferential rights for geming dividend and repayment of capital
at the time of winding up.
Types of Preference Shares
1.Cumulative Preference Shares: Cumulative Preference Shares are those shares which
carry the right to cumulative dividends. If the company fails to pay the dividend in a particular
year, due to insufficiency of profes, such dividend is payable even out of future profits.
2.Non-Cumulative Preference Shares: These are the Preference Shares which do not carry
the right to receive arrears of dividend. If the company fails to pay dividend in a particular
year, that dividend need not be paid out of future profits.
3.Participating Preference Shares: Participating preference shares are those shares which
have the right to participate in the surplus profits and assets of the company after paying the
equity shareholders, in addition to their fixed rate of dividend and return of capital
4.Non-participating Preference Shares: Preference shares which have no right to participate
on the surplus profits and assets of the company are called Non-participating Preference
Shares
5.Redeemable Preference Shares: Redeemable preference shares are those shares which
can be redeemed after the expiry of a fixed period.
6.Irredeemable Preference Shares: These are shares which are redeemed (repaid) only on
winding up of the company.
7.Convertible Preference Shares: These are the shares which are converted into equity
shares after a specified period. The holders of the shares may be given a right to convert
their holdings into equity shares
8.Non-convertible Preference Shares: Preference Shares which are not convertible imo
equity shares after a fixed period are called Non-convertible Preference Shares.
Features of Preference Shares
1.As per the terms of issue and Articles of Association, a fixed rate of interest is paid on
preference shares
2.Preference shares get some preference over equity shares in respect of dividend and
repayment of capital at the time of winding up.
3.Preference shareholders do not enjoy voting rights
4.Preference shares have fixed maturity date and will have so repay after the fined period.
5.Preference shares are hybrid form of security as it includes some features of equity and
debt.
Advantages of Preference Shares
1.Preference shares add to the equity hase of the company by strengthen its financial
position
2.Preference shares save the company from paying higher rate of interest.
3.Issue of preference shares doesn't create any sort of charge against assets of the
company.
4.Preference shares will not affect existing control of the company as the preference
shareholders have voting rights only on the matters affecting their interest.
5.Financing through preference shares is cheaper than that of equity financing.
6.It is useful to investors who want to get higher rate of return with low risk.
7.Preference shareholders have a prior claim on the assets of the company on liquidation.
Disadvantages of Preference Shares
1.Preference dividend is not deductible as an expense for taxation purposes out of the
profits of the company
2.In case of cumulative preference shares, arrears of dividend have to be declared before
anything can be paid to the equity shareholders of the company
3.Preference shares dilute the claim of equity shareholders over the assets of the company.
4.Compulsory redemption of preferences shares on maturity will lead to substantial outflow
of cash.
5.The cost of capital of preference shares is higher than cost of debt.
2.Issue of Debentures
A company may raise long term finance through public borrowings. The publ borrowing is
done through the issue of debentures. Debenture is an acknowledgement debt. It is only a
written document issued by a company as an evidence of its debt capital.
A debenture is "an instrument in writing acknowledging a debt under the seal of the
company, usually secured by a fixed or floating charge on the assets of the company bearing
a fixed rate of interest and repayable within or after a specified period of irredeemable during
the existence of the company"
Kinds of Debentures
i. On the basis of Transferability
a. Registered Debentures: These are debentures registered in the books of the company
b. Bearer Debentures: If the names and other details of the debenture holders are not
recorded in the "Register of Debentures of the company, they are called bearer debentures.
ii. On the basis of Security
a. Secured or Mortgage Debentures: These are debentures which are secured by a fixed or
floating charge on the assets of the company.
b. Simple or Unsecured Debentures: These debentures carry no security with regard to
repayment of principal and interest. They are also called 'naked debentures'.
iil. On the basis of permanence (Redeemability)
a. Redeemable Debentures: Redeemable debentures are those debentures which are
redeemed after a specified period of time or after maturity period.
b.Irredeemable Debentures: Debentures, which are not repayable during the life time of the
company are called irredeemable debentures. They are also called perpetual debentures.
iv. On the basis of convertibility
a. Convertible debentures: Convertible debentures are those debentures which can be
converted into shares of the same company at the option of the holders.
b. Non-convertible Debentures: Debentures which are not convertible into shares of a
company are called non-convertible debentures.
v. Priority
a. First Mortgage Debentures: These debentures are payable first out of the property
charged.
b.Second Mortgage Debentures: These debentures are payable after satisfying the first
mortgage debentures.
Characteristics of Debentures
1.A Fixed rate of interest is payable on debentures.
2.Debentures create charge against assets of the company. The charge may either fixes or
Boating charge.
3.Interest paid on debentures is tax deductable expense, while computing taxable profia of
the company
4.Most of the debentures are redeemable at maturity.
5.Debenture interest is a charge against the profit of the company.
6.Debenture holders have option for converting their holdings into equity shares.
7.Debt financing does not result into dilation of control in the management of the company
Advantages of Debentures
1.It provides long term finance to the company
2.The rate of interest payable is less than the rate of dividend on shares.
3.Interest on debenture is a tax deductible expense
4.Debt financing does not result in the dilution of control.
5.Debenture capital provides the benefits of trading on equity.
5.Debentures provide fixed, stable and regular source of income to the investors.
Disadvantages of Debentures
1.It is a permanent burden on the company to repay the principal on maturity.
2.Charge on assets of the company restricts it from the use of debenture financing.
3.The increased use of debt financing usually increases the financial risk. The increased
financial risk may lead to financial distress and liquidation.
4.Cost of raising finance through debentures is high because of high stamp duty.
5.It is not desirable to issue debentures by a company having irregular earnings
6.Debenture holders do not have any controlling power over the management of the
company because they do not have any voting rights.
3.Issue of Bonds
A bond is an instrument, whereby, one person binds himself to another for payment of a
specified sum of money on a specified date.
Types of Corporate Bonds
1.Bearer Bonds: In this type of bonds, the amount is payable to the holders of the
instruments at the time of maturity.
2.Registered bonds: In this case, the amount is payable to the person, whose name is
mentioned in the register of the company.
3.Zero coupon bonds or deep discount bonds: This is a new type of bond which has no
periodic interest payment.
4.Sinking fund bonds: In the case of sinking fund bonds, the issuing company redeems a
fraction of the issue every year.
5.Junk bonds: Junk bonds are corporate bonds that are high risk and high return bonds
developed in USA. These are high yield bonds with higher risk of default and other adverse
credit events
6.Privately placed bonds: These are privately placed bonds and are not negotiable These
are usually issued to institutional investors.
7.Bunny bonds: These are the bonds issued with the right to reinvest the income inte the
bonds with the same terms and conditions of the host bond.
8.Secured Premium Notes (SPN): These instruments are issued with detachable warrants
and are redeemable after a notified period, normally 4 to 7 years.
4.Retained Earnings
A company does not generally distribute the entire earnings amongst its shareholders as
dividend. A portion of divisible profit is retained in the business for future use. The portion of
profit retained in the business for future use is known as retained earnings. The process of
retaining a portion of profit for reinvestment in the business is known as ploughing back of
profit. It is an internal source of financing or self-financing.
Need for Ploughing Back of Profit
1.For the replacement of old assets.
2.For the expansion and growth of the business.
3.For meeting fixed and working capital requirements.
4.For improving the efficiency of various assets.
5.For enabling company to become self-dependent.
6.For redemption of loans and debentures.
Factors determining Ploughing Back of Profits
1.Earning capacity: The amount of net profit earned is an important determinant of internal
savings. Higher the net profit earned by a company, the greater is its capacity to plough back
profits.
2.Age of the company: The age of the company also influences the amount of retained
earnings. New companies are generally unable to retain much profits due to their desire to
satisfy the shareholders.
3.Future Financial Requirements: The future plans of the company regarding modernisation
and expansion also affect the amount of retained earnings. A company with more expansion
plans may retain major portion of the earnings to finance such projects.
4.Dividend Policy: The dividend policy of a company determines the extent to which the
profits can be retained for reinvestment in the business. If a company follows a liberal and
regular dividend policy, it may end up retaining lesser profits.
5.Taxation Policy: If the rate of tax is high, then the company may have lesser amount of
internal savings. If the corporate income tax is low and tax on dividend is high, the company
may resort to retain a major part of its profit for future.
5.Institutional Finance
Institutional finance is a source of finance which is provided by the specialized financial
institutions.
i. The Industrial Finance Corporation of India (IFCI)
The IFCI was established in 1948 under an Act of Parliament with the basic object of
providing industrial finance (medium and long-term credit) to industrial concerns, especially
to small scale industries in India.
ii. The Industrial Credit and Investment Corporation of India (ICICI)
ICICI was established in 1955, as a private sector Development Bank with the primary
objective to provide development finance to enterprises in the private sector. The main
purpose for which financial assistance is extended by ICICI is for the purchase of capital
assets such as land, building and machinery.
iii. Industrial Development Bank of India (IDBI)
The Industrial Development Bank of India (IDBI) was established on 1st July, 1964, under
the Industrial Development Bank of India Act, 1964, as a wholly owned subsidiary of the
Reserve Bank of India. In terms of the Public Financial Institutions Laws (Amendment) Act,
1975, the ownership of IDBI has been transferred to the Central Government with effect from
February 16, 1976.
v. National Bank for Agriculture and Rural Development (NABARD)
NABARD is the apex institution that provides all types of credit to various sectors in the rural
economy, such as, agriculture, small scale industries, tiny and cottage industries,
handicrafts, in an integrated way for rural development. It came into existence on July 12,
1982.
iv. Small Industries Development Bank of India (SIDBI)
In order to ensure larger flow of financial and non-financial assistance to the small scale
sector, the Government of India set up the Small Industries Development Bank of India
(SIDBI), under a special Act of the Parliament in October 1989 as a wholly owned subsidiary
of the IDBI. The Bank commenced its operations from April 2, 1990, with its head office in
Lucknow.
6.Sale of fixed assets
Sale of fixed assets like land and building, lease hold premises which are not in use form a
long term source of finance to corporations.
7.Innovative Sources
i.Hire purchase financing
It is a new development of finance mechanism in certain selected sectors of Indian
Industries. Under the hire purchase financing the organisations are able to use high value
msets with minimum capital. It is an agreement between buyer and seller of the property.
ii.Lease Financing
Leasing is an agreement between the owner of the property and the user of the same,
whereby, the owner of the property provides exclusive right to the user to use the asset
without owning the same for a periodical payment called lease rentals.
iii. Venture Capital
Venture capital is a long-term risk capital to finance high technology projects which Involve
risk but at the same time has strong potential for growth.
Iv. Indian Depository Receipts (IDR)
An Indian Depository Receipt (IDR) enables foreign companies to raise funds from the
Indian securities market. IDR is an instrument denominated in Indian Rupees in the form of a
domestic depository receipt against the underlying equity shares of foreign Issuing company.
v. Euro Issues
Euro issue means an issue made abroad through instrument denominated in foreign
currency and listed on European Stock Exchange. But the subscription for it may come from
any part of the world other than India.
Short-term Sources
1.Trade Credit
Sellers or suppliers of different kinds of products or raw materials provide credit to deir
customers. The credit offered by the seller or supplier is known as trade credit or hillis
payable. It is a very important source of short-term finance
2.Bank Credit
Banks provide short-term finance in the form of over draft, cash credit, discounting of trade
bills and letters of credit to its customers.
3.Public Deposit
Firms may mobilise savings from the general public and it is termed as 'public deposit. It is a
very old system of financing.
4.Inter-corporate Deposits
A deposit made by one company in another company is known as inter corporate deposit. It
is an important short-term source of finance for firms in India.
5.Advances from Customers
Usually, sellers or producers receive whole or part of the amount of goods in advance and
such advance remains with them till the supply of goods. Normally, no interest is paid on this
amount
6.Commercial Paper (CP)
Commercial paper is a short-term money market instrument. It is a promissory note which is
negotiable by endorsement and fit for delivery with a fixed maturity period between one
month to one year. It helps to raise short-term deal at attractive rates.
7.Factoring
Factoring is a business activity in which a financial intermediary called factor takes the
responsibility of collecting the debtors or receivables of a manufacturing or trading concern.