Sources of finance

on the basis of period- long term

fulfill the financial requirements of an enterprise exceeding 5 years. includes equity shares, preference shares, retained earnings, debentures, loan from financial institutions and loan from banks

fixed capital requirement

funds are required to purchase fixed assets like land and buildings, plant and machinery, and furniture and fixtures these funds remain invested for a long time the amount of fixed capital and the need varies from business to business

on the basis of ownership- owner's funds

funds that are provided by the owners of the enterprise , which may be a sole trader or partners or sharehlders of a company apart from capital it can also be profits that are reinvested the owner's capital remains invested for a long time and id not required to be refunded during the life period of the business. such capital forms the basis on which owners acquire the right of control of management issue of equity shares and retained earnings are two important sources

debentures

important instrument for raising long term debt capital debentures bear a fixed rate of interest an acknowledgement that the company has borrowed a certain amount of money which it promises to repay at a future date debenture holders are termed creditors of the company and are paid amount of interest at specific intervals companies to be rated by agencies like CRISIL

on the basis of source of generation- external sources

includes those sources that lie outside the organization when large amounts of money is to be raised, external sources are preferred costlier than internal sources most cases, businesses have to mortgage their assets as security includes loan from banks, preference shares, public deposits, debentures, lease financing, commercial papers, trade credit and factoring

on the basis of source of generation

internal sources external sources

on the basis of period

long term medium term short term

on the basis of period- short term

most common for financing of current assets such as accounts recievable and inventories. seasonal businesses that must build inventories in the anticipation of a seasonal sale need short term finances in the interim period includes trade credit, factoring, banks and commercial paper also used by wholsalers and traders who have their assets tied up in inventories znd require large amount of money for a short period

equity shares

most important source for raising long term capital represent the ownership of the company and hence they are called ownership capital or owner's funds necessary for the company's creation shareholders paid on the basis of earnings, they are also called residual owners as they receive only what is left. enjoy rewards, risks and have limited liability. can participate in management

working capital requirement

needs funds for day to day requirements used for holding current assets like bills receivable and meeting current expenses like wages, rent the amount varies, eg. a company having credit sales or a slow sales turnover may require more requirement increases with the grwoth and expansion of the business

public deposits- limitations

new companies find it difficult to raise funds through public deposits unreliable source of funds as the public may not respond as the time of need collection of money is difficult, especially in case of large size of deposits

preference shares- demerits

not suitable for investors wanting high returns preference capital dilutes the claims of equity shareholders over the company rate of dividend higher than the rate of interest on debentures dividend paid is not deductible from profits as expense. thus there is no tax saving

equity shares- demerits

not suitable for investors who want steady income cost of equity shares more than other sources dilution of voting power lots of formalities and delays in issuing equity shares

classification of sources of funds

on the basis of period on the basis of ownership on the basis of source of generation

commercial paper- demerits

only financially sound and highly rated firms can raise money through commercial paper. the amount of money that can be obtained is limited to the excess liquidity of the person supplying it. impersonal method of financing, cannot extend the maturity of a commercial paper if a company is unable to redeem its paper due to financial difficulties.

on the basis of ownership

owner's funds borrowed funds

retained earning- merits

permanent source of funds does not involve any explicit cost in the form of interest, dividend or floatation cost as the funds are generated internally, a higher degree of operational flexibility enhances the capacity to absorb unexpected losses may lead to an increase in the market price of the equity shares of the company

preference shares

preference shareholders enjoy a preferential position over equity shareholders as they receive a fixed rate of dividend and receive their capital right after the creditors' claims are settled. do not have voting rights resemble debentures as they bear a fixed rate of return. resemble equity shares as dividend is payable only at the discretion of the directors and only out of profit after tax

debentures- merits

preferred by investors who want fixed income at lesser risk they are fixed charge funds and do not participate in profits of the company suitable when the sales and earnings are stable does not dilute control of equity shareholders on management financing lesser as compared to equity capital as it is tax deductible

preference shares- merits

provides steady income in the form of fixed raye of return and safety of investment useful for investors who are not willing to take risks preference shareholders do not enjoy voting rights so no dilution of control payment of a fixed rate of dividend may enable the company to declare higher rates of dividend for the equity shareholders in good times preference shareholders have preference over equity shareholders no charges on the assets

on the basis of ownership- borrowed funds

refer to the funds raised through loans or borrowings. sources include loans from commercial banks or financial institutions, issue of debentures, public deposits and trade credit provide funds for a specified period on certain terms and conditions and have to be repaid after that term a fixed rate of interest to be paid. this could prove to be a burden on the business in some cases

public deposits- merits

simple procedure and no restrictive conditions like the ones found in a loan agreement cost of public deposits is lower than cost of borrowings from banks do not create any charge on the assets of the company as the depositors have no voting rights, no dilution of control

commercial paper- merits

sold on an unsecured basis and does not contain restrictive conditions freely transferable, high liquidity provides more funds than other sources provides a continuous source of funds companies can park their excess funds in it thereby earning good return

equity shares- merits

suitable for investors willing to assume risk for higher returns payment of dividend not compulsory serves as permanent capital as capital to be repaid only at the time of liquidation provides credit worthiness no charge on the assets democratic control as shareholders enjoy voting rights

share capital

the capital obtained by the issue of shares.

what are shares

the capital of the company is divided into small units. these units are called shares

factoring- working, history and examples

the factor charges fees for the services rendered factoring appeared in the early nineties as a result of RBI initiatives organisations include sbi factors and commercial services ltd. canbank factors ltd. sbi, canara bank, pnb etc and also include non banking finance companies and third party agencies

equity share capital and preference share capital

the money raised by issue of equity shares is called equity share capital the money raised by the issue of preference share capital is called preference share capital

shareholder

the person holding a share

business finance

the requirement of funds by the business to carry out its various activities is called business finance

on the basis of source of generation- internal sources

those that are generated within the business eg. by accelearting collection of recievables, disposing of surplus inventories and ploughing back of profits. such funds can only fulfill limited needs of the business

on the basis of period- medium term

when funds are required for a period of more than one year but less than five years includes loan from banks, public deposits, loan from financial institutions and lease financing

lease financing- demerits

agreement may impose certain restrictions. the normal business operations may be affected if the lease is not renewed may result in higher payout obligation in case the equipment is not found useful and the lessee opts for premature termination of the agreement the lessee never becomes the owner of the asset.

debentures- demerits

as fixed charge instruments, they put a permanent burden on the earnings of the company in case of redeemable debentures, the company has to make provisions even at the time of difficulty the capacity of the company to borrow further funds diminishes

trade credit- demerits

availability of easy and flexible trade credit facilities may induce the firm to indulge in overtrading which may add to the risks of the firm only limited amount of funds can be generated generally a costly source of funds as compared to most other sources of raising money

factoring- merits

cheaper than obtaining funds from other sources like bank credit with cash flow accelerated by factoring, the client is able to meet his liabilities promptly flexible and ensures a definite pattern of cash inflows from credit sales . ensures security for a debt that may otherwise be unable to obtain does not create any charge on the assets the client can concentrate on other functional areas of the business

trade credit- merits

continuous and convenient source if funds may be readily available if creditworthiness is good and known to the seller promote sales of an organisation it may use trade credit to finance the increase in inventory level does not create any change on the assets of the firm while providing funds

trade credit

credit extended by the trader to another for the purchase for goods and services facilitates the purchase of supplies without immediate payment commonly used as a source of short term financing granted to those who have good financial standing the volume and period of credit depends on various factors

CRISIL

credit rating and information services of india ltd. keeps the track record of companies, its profitability, its debt raising capacity, credit worthiness and the perceived risk of lending

public deposits

deposits that are raised by organizations directly from the public rates of interest offered are higher than those on bank deposits can be done by any individual by filling out a form the organisation issues a deposit receipt in return depositors get higher interest rate and these are lesser than the cost of borrowings from banks usually for a period upto three years regulated by RBI fulfills medium and short term financial requirements

commercial paper

emerged as a source of short term finance in the early nineties an unsecured promissory note issued by a firm to raise funds for a short period from 90 to 634 days issued to other business firms, insurance companies, pension funds, banks large amounts raised good credit rating required regulated by rbi

lease financing- merits

enables the lessee to acquire the asset with a lower investment simple documentation makes it easier to finance assets lease rentals paid by the lessee are deductible for computing taxable profits provides finance without diluting the ownership or control of the business does not affect the debt raising capacity of the enterprise risk of obsolescence borne by the lesser which allows greater flexibility to the lessee

the two types of shares that are normally issued by a company

equity shares preference shares

retained earning- demerits

excessive ploughing back may cause dissatisfaction among the shareholders as they would get lower dividends it is an uncertain source of funds as the profits of the business keep fluctuating the opportunity costs associated with these funds is not recognised by many firms. this may lead to suboptimal use of funds

factoring- demerits

expensive when the invoices are numerous and smaller in amount the advance is available at a higher interest cost than the usual rate of interest the factor is a third party to the customer who may not feel comfortable while dealing with it

factoring - services provided

financial service under which the factor renders various services: 1) discounting of bills- under this the receivables on account of sale of goods/services are sold to the factor at a discount. there are two methods: recourse- client not protected form the risk of bad debts non recourse- the factor assumes the entire credit risk 2) providing information about the creditworthiness of prospective clients and offer consultancy services

retained earning

a company does not distribute all its earnings as dividends amongst the shareholders a portion of the net earnings is retained for use in the future. this is called retained earnings source of self financing or ploughing back of profits profit earned depends on many factors like net profit, dividend policy and the age of the organization

lease financing

a contractual agreement whereby one party i.e. the owner of an asset grants the other party the right to use the asset in return for a periodic payment owner of the assets is called the lessor and the party that uses the assets is known the lessee the fixed periodic amount is called the lease rental terms and conditions given in the lease contract helps in modernisation and diversification used for computers, electronic equipment etc