UNIT 1: FINANCIAL MANAGEMENT – NATURE AND SCOPE

ASSIGNMENT
1. Retained earnings are also internal sources of funds. Explain.

Retained earnings are considered internal sources of funds because they originate from a company's
profits that are retained and reinvested in the business rather than distributed to shareholders as
dividends. Let's break down the concept:

1. Accumulation of Profits:
Retained earnings represent the cumulative net profits of a company that have not been paid out as
dividends to shareholders. These profits are generated through the company's normal business
operations.
2. Internal Reinvestment:
Instead of distributing all the profits to shareholders, a portion is retained by the company. This
internal reinvestment is a strategic decision made by management to fund various activities within
the company.
3. Funding Growth and Operations:
Retained earnings serve as a source of funds for the company's expansion, research and
development, acquisitions, debt reduction, or other strategic initiatives. This internal funding helps
the company to grow and improve its operations without relying on external sources like loans or
issuing additional shares.
4. Financial Stability: Companies with substantial retained earnings are often viewed favorably by
investors and creditors. It indicates financial stability and the ability of the company to generate
consistent profits over time.
5. Flexibility and Control:
By relying on retained earnings, a company maintains control over its financial decisions. Unlike
external financing, which may come with conditions or interest payments, using retained earnings
provides flexibility and autonomy.
6. Shareholder Value:
Although retained earnings are not distributed as dividends, they can contribute to an increase in
shareholder value. If the company reinvests retained earnings wisely and generates higher returns,
shareholders benefit through capital appreciation. Earnings Retention Policy: The decision to retain
earnings is part of a company's earnings retention policy. This policy is influenced by factors such as
the company's growth prospects, capital requirements, and the desire to reward shareholders through
capital gains.
In summary, retained earnings serve as an internal source of funds because they represent profits
generated by the company that are retained and reinvested internally. This mechanism allows the
company to fund its growth, operations, and strategic initiatives without relying on external
financing.
 2. Why are public deposits medium term source of finance?

Public deposits are considered a medium-term source of finance for companies. This is because
public deposits involve borrowing money from the public for a specified period, typically ranging
from a few months to a few years. Here are some reasons why public deposits are categorized as a
medium-term source of finance:

Intermediate Maturity Period: Public deposits usually have a maturity period ranging from a few
months to a few years. This intermediate duration distinguishes them from short-term sources of
finance (e.g., trade credit, bank overdrafts) with shorter repayment periods and long-term sources
(e.g., debentures, equity) that have longer repayment horizons.

Flexibility in Tenure: The specific tenure of public deposits can be negotiated between the
company and the depositors, providing a degree of flexibility. This flexibility allows companies to
match the tenure of deposits with their specific funding needs, making it suitable for medium-term
financing requirements.

Meeting Medium-Term Obligations: Companies often use public deposits to meet medium-term
financial obligations, such as financing a specific project, purchasing equipment, or funding
working capital requirements for an extended period.

Avoidance of Long-Term Commitments: Public deposits are a way for companies to raise funds
without entering into long-term commitments. This is beneficial when a company does not want to
commit to fixed interest payments over an extended period and prefers a relatively shorter-term
obligation.

Interest Rate Considerations: The interest rates associated with public deposits are usually lower
than those of long-term debt instruments. This makes public deposits a cost-effective option for
medium-term financing needs compared to issuing long-term bonds or debentures.

Reduced Uncertainty: Unlike short-term financing that requires frequent renewal and may be
subject to interest rate fluctuations, medium-term financing through public deposits provides a more
stable and predictable financial environment for companies.

Diversification of Funding Sources: Companies often employ a mix of short-term, medium-term,

and long-term financing sources to diversify their funding structure. Public deposits contribute to
this mix by providing a medium-term component, helping to manage risk and optimize the overall
cost of capital.

In summary, public deposits are considered a medium-term source of finance because they offer an
intermediate tenure, flexibility, and a means for companies to meet their medium-term financial
obligations without committing to long-term debt structures. This flexibility allows companies to
tailor their financing to specific needs and optimize their overall capital structure.
3. Differentiate between owners funds and borrowed funds.

Owner’s Fund Borrowed Fund

The Owner’s Funds are the total amount The Borrowed Funds are the funds that a
invested by the owner of an enterprise and the business raises through loans or
accumulated profits that they have reinvested borrowings from outside parties.
in the business.

The Owner’s Fund is a permanent source of The Borrowed Fund is a temporary source
investment for a business that remains with of investment for a business that is paid
the company till it winds up its operations. back to the creditors after the completion
of a specific period of time.
The control of the enterprise rests with the The providers of Borrowed Funds do not
individuals or entities that provide the capital get any stake in the control of the
for the business. enterprise by providing funds.
The returns on these funds may fluctuate on a The creditors get a fixed rate of interest
yearly basis based on the profits that a on the funds provided by them on a
business earns from its operations. periodic basis.
The Owner’s Funds are not backed by any The Borrowed Funds are backed by the
security of any asset. security of assets.
The reward for Owner’s Funds is the dividend The reward for borrowers funds is the
that they get at the end of a year. fixed rate of interest that they get at the
end of a year.
The owners get second priority in terms of The borrowers get first priority in terms of
return of capital. The dividend on the Owner’s return of capital. The interest on the
Fund is paid only after the payment of interest Borrowed Funds gets paid before the
on the Borrowed Funds. payment of dividend on the Owner’s
Funds.
 4. Classify sources of funds on the basis of source of generation.

Classification of source of funds on the basis of source of generation are as under:

1. Internal Sources:
Every business organization has some funds which are kept aside for future uncertainties
and needs. When the funds are generated internally, then they are said to be internal
sources of funds. Internal sources of funds have their own merits and demerits. The
biggest advantage of internal sources is that these are a permanent source of funds that
could be easily availed, and does not involve any explicit cost as it belongs to the
business enterprises only. However, internal funds lead to various risks to the firm and
can accomplish only the limited needs of the firm. For example, equity share capital,
retained earnings, etc.

2. External Sources:
When a large amount of funds is required by a business enterprise, then it opts for
external financing. Therefore, external sources of finance are the sources that are
obtained from outside the business. The cost of raising funds from external sources is
more than the cost from internal sources. Sometimes, an organization has to mortgage its
assets as security. For example, lease financing, factoring, preference shares,
Commercial papers, etc.

5. Why are long term sources of funds called so?

Long-term sources of funds are called so because they represent financial resources that are
obtained for an extended period, typically exceeding one year. These funds are used to
finance projects or investments that have a longer gestation period and are expected to
generate returns over an extended timeframe. Here are some reasons why they are termed
"long-term":

1. Extended Repayment Period:

Duration: Long-term sources of funds involve financial arrangements with a
maturity period exceeding one year. This could include loans with multi-year
repayment schedules or the issuance of long-term securities such as bonds or
debentures.
2. Financing Capital Expenditures:
Purpose: Long-term funds are often acquired to finance capital expenditures, which
are investments in assets like buildings, machinery, and equipment. These assets
have a long useful life and are not expected to generate returns immediately.
3. Nature of Investments:
Long-Term Projects: Businesses use long-term funds for projects with lengthy
development, construction, or implementation phases. These projects may take
several years to become operational and start generating revenue.
4. Stability and Predictability:
Stable Commitments: Long-term financing arrangements provide stability to a
business by offering a consistent source of funding for a significant period. This
stability is particularly important for businesses with long-term growth and
expansion plans.
5. Risk and Return Considerations:
Risk of Project Failure: Projects funded by long-term sources often involve higher
capital outlays and, consequently, higher risk. However, they also have the potential
for higher returns over the long run.
6. Asset Matching:
Matching Durations: Long-term funds are aligned with the expected useful life of
the assets being financed. This practice of matching the duration of funds with the
life of assets helps in avoiding liquidity issues.
7. Cost of Capital:
Cost Factors: The cost associated with long-term funds may include interest
payments on loans or returns to investors through dividends or interest on long-term
securities. The cost structure is spread over an extended period.
8. Institutional Investors:
Preference of Investors: Institutional investors, such as pension funds and
insurance companies, often prefer long-term investments that align with their long-
term liabilities. This preference contributes to the availability of long-term funding
sources.

In summary, long-term sources of funds are named as such due to their extended
maturity periods and their association with funding commitments for projects and
investments that span over several years. These sources provide businesses with the
financial resources needed for sustained growth, capital asset acquisition, and the
implementation of strategic initiatives over the long term.