Sources of Finance

Contents

Patterns of Financing
Few Terms
Sources of Long Term Finance
Sources of Short Term Finance
 Patterns of Financing

Long Term Financing

Short Term Financing
 Few Terms

• Authorised Capital: The amount of capital that a company can potentially

issue, as per its memorandum, represents the Authorised Capital.
• Issued Capital: The amount offered by the company to the investors is
called the Issued Capital.
• Subscribed Capital: That part of issued capital, which has been subscribed
to by the investors represents the Subscribed Capital.
• Paid-up Capital: The actual amount paid up by the investors is called the
Paid-up Capital. However, typically the issued, subscribed, and paid-up
capital are the same.
 Par Value: The par value of an equity share is the value stated in the memorandum and written
on the share scrip. The par value of equity shares is generally Rs. 1, Rs. 2, Rs. 5, or Rs. 10.
 Issue Price: The issue price is the price at which the equity share is issued. Often, the issue price
is higher than the par value. When the issue price exceeds the par value, the difference is
referred to as the share premium. It may be noted that the issue price cannot be, as per law, lower
than the par value.
 Book Value: The book value of an equity share is equal to:
Paid-up equity capital + Reserves and surplus
Number of outstanding equity shares
• Quite naturally, the book value of an equity share tends to increase as the ratio of reserves and
surplus to paid-up equity capital increases.
 Market Value: The market value of an equity share is the price at which it is traded in the
market. This price can be easily established for a company, which is listed on the stock market
and actively traded. For a company, which is listed on the stock market but traded very
infrequently, it is difficult to obtain a reliable market quotation.
• The market price is determined by a variety of factors like current earnings, growth prospects,
risk, and company size.
 Sources of Long Term Finance

Equity Shares
Preference Shares
Debentures
Term Loans
Retained Earnings
Special Financial Institutions
 Equity Shares
 Equity or ordinary shareholders are the real owners of the company. Equity capital
represents ownership capital, as equity shareholders collectively own the
company. They enjoy the rewards and bear the risks of ownership.
 The shareholders can participate in the management of the company. They also
have residual claim on the income/assets of the company. The rate of dividend is
determined by directors on the basis of annual profits.
Characteristics of Equity Shares
Residual Claim on Income
Right in Liquidation
Limited Liability
Pre-emptive Rights
Right to Control
Residual Claim on Income
Equity shareholders have a residual claim on the income of the company. They have the
claim on income only after the payment of preference dividend. If the profits are
insufficient to pay the dividends, the directors may skip the equity dividend.
Right in Liquidation
As in the case of income, equity shareholders have a residual claim over the assets of the
firm in the event of liquidation. Claims of all others debenture holders, secured lenders,
unsecured lenders, other creditors, and preferred shareholders are prior to the claim of
equity shareholders.
More often than not, equity shareholders do not get anything in the event of liquidation
because the liquidation value of assets is not adequate to meet fully the claims of others.
Limited Liability
The liability of the equity shareholders is limited to the amount of shares they have
purchased. In case of liquidation, they have the liability to pay if the shares are partly
paid-up. If the shares are fully paid-up, they are not liable to pay anything. This provides
them a facility to enjoy ownership without unlimited liability.
Pre-emptive Rights
• Equity shareholders are provided with pre-emptive rights. Pre-emptive right
means the right to purchase new shares issued by the company.
• As per Section 81 of the Companies Act, 1956, whenever a company proposes
to increase its share capital by further issue of shares, it must offer such shares
to holders of existing equity shares in proportion of existing shareholding.
• Such shares are called as right shares and such right of shareholders is known
as pre-emptive right. It protects shareholders from dilution of their financial
interest in the company.
Right to Control
• The equity shareholders have full right to control the company as owners to
the company. They enjoy voting rights in the meetings of the company.
• Equity shareholders, as owners of the firm, elect the board of directors and
enjoy voting rights at the meetings of the company in person or by proxy
(except in a poll) or by postal ballot.
• The board of directors, in turn, selects the management which controls the
operations of the firm. Hence, equity shareholders, in theory, exercise an
indirect control over the operations of the firm.
 Preference Shares
• Preference shares are those shares on which shareholders enjoy two
preferences over the equity shareholders. These preferences are:
Payment of dividend out of profits
Repayment of capital in case of liquidation
• The preference shareholders do not have any right to participate in the
management of the company. All preference shares are redeemable within
10 years.
• A fixed rate of dividend is paid on these shares. These shareholders do not
have any voting right. However, they get the right to vote if their interest
is affected by any decision of the company.
• Preference capital represents a hybrid form of financing — it partakes
some characteristics of equity and some attributes of debentures.
• It resembles equity in the following ways:
1. Preference dividend is payable only out of distributable profits
2. Preference dividend is not an obligatory payment (the payment of
preference dividend is entirely within the discretion of directors)
3. Preference dividend is not a tax-deductible payment
• Preference capital is similar to debentures in several ways:
1. The dividend rate of preference capital is fixed — since preference
shares in India usually carry a cumulative feature with respect to
dividends, unpaid dividends are carried forward and payable when the
dividend is restored
2. The claim of preference shareholders is prior to the claim of equity
shareholders
3. Preference shareholders do not normally enjoy the right to vote
4. Preference capital is typically repayable
Types of Preference Shares

Cumulative and Non-Cumulative Preference Shares

• Under cumulative preference shares, the shareholders have the right to
recover the arrears of dividend in the years in which the company has the
sufficient profits.
• On the other hand, the holders for non-cumulative preference shares do not
have any right to recover the arrears of dividend in next years.
• Redeemable and Non-redeemable Preference Shares
• If the preference shares can be redeemed at the option of the company
after a fixed period of time, then these shares are called as redeemable
preference shares.
• On the opposite side, if the amount of preference shares is not to be paid
back to the shareholders in the lifetime of the company, such shares are
called as non-redeemable preference shares.
Participating and Non-participating Preference Shares
• If the shareholders of preference shares have the right to participate in the
additional profits in addition to the fixed rate dividend, such shares are
called as participating preference shares. In such case, firstly the dividend to
preference shareholders will be paid at a fixed rate and the equity shareholders
will be paid at a reasonable rate. If still any balance of profit remains, then
these shareholders will get some more part of profits as dividend. The rate of
the additional dividend is determined at the time of issuing these shares.
• On the other hand, if the preference shareholders do not have any right to
participate in the additional profits, such shares are known as non-
participating preference shares.
Convertible and Non-convertible Preference Shares
• If the shareholders have the right to get their shares converted into equity
shares after a certain period of time, then these shares are called as
convertible preference shares. The period and conversion ratio must be made
clear in the Articles of Association or under the terms of issue.
• On the other hand, if the preference shares are not to be converted into
equity shares, then these shares are called as non-convertible preference
shares.
 Debentures
• A debenture is a type of loan acknowledgement, which is taken by the
company from the public. A company can issue various types of debentures.
• Debenture holders are the creditors of company. The obligation of a company
toward its debenture holders is similar to that of a borrower who promises to
pay interest and principal at specified times.
• Debentures often provide more flexibility than term loans as they offer
greater variety of choices with respect to maturity, interest rate, security,
repayment, and special features.
• A debenture issued by a company is usually in the form of a certificate, given
under the seal of the company which contains the terms of the repayment of
the principal sum at a specified date and the terms of payment of interest at a
fixed percent.
• According to Section 2 (12) of the Companies Act, "Debenture includes
debenture stock, bonds and any other securities of a company, whether
constituting a charge on the assets of the company or not.
Types of Debentures

Secured and Unsecured Debentures

• Secured debentures are those which are secured either on particular assets of
the company called fixed charge or on all assets of the company in general,
called a floating charge. In India, debentures have necessarily to be secured.
• Unsecured debentures are those which are not given any security. The
holders of such debentures are treated as unsecured creditors at the time of
liquidation of the company.
Registered Debentures
• Registered debentures are those which are payable only to those holders
whose names and addresses are recorded in a register of the company called,
“Register of Debentures holders”.
Bearer Debentures
• Bearer debentures are those which are payable to the bearer or holder of the
debenture. These are transferable by mere delivery and the company does not
keep any record of names and addresses of debenture holders.
Redeemable and Irredeemable or Perpetual Debentures
• Redeemable debentures are those debentures, which will be repaid by the
company at the end of a specified period or by instalments during the life of
the company.
• Irredeemable debentures are those debentures, which are not repayable by the
company during its lifetime. These debentures are repayable only at the time
of liquidation of the company.
Convertible and Non-convertible Debentures
• Convertible debenture holders are given an option to convert them into equity
or preference shares at a stated rate of exchange after a certain period.
• Non-convertible debentures are those debentures that cannot be converted
into equity or stocks of the company. NCDs have a fixed maturity date and
the interest can be paid along with the principal amount.
• They offer relatively higher interest rates when compared to convertible
debentures.
 Term Loans
• Term loans, also referred to as term finance, represent a source of debt finance which is
generally repayable in less than 10 years.
• A term loan is a monetary loan that is repaid in regular payments over a set period of
time. Term loans usually last between one and ten years, but may last as long as 30 years
in some cases.
• A term loan is a type of advance that comes with a fixed duration for repayment, a fixed
amount as loan, a repayment schedule as well as a pre-determined interest rate. A
borrower can opt for a fixed or floating rate of interest for repayment of the advance.
• Term loan is a medium to long-term source financed primarily by banks and financial
institutions.
• They are mainly employed to finance acquisition of fixed assets and working capital
margin. They are also used for financing of expansion, diversification and modernization
of projects.
• Term loans differ from short-term bank loans which are employed to finance short-term
working capital need and tend to be self-liquidating over a period of time, usually less
than one year.
 Retained Earnings
• Retained Earnings are the portion of a business's profits that are not distributed
as dividends to shareholders but instead are reserved for reinvestment back into
the business.
• Retained earnings are that portion of equity earnings (profit after tax less
preference dividends) which are ploughed back in the firm. Because retained
earnings are the sacrifice made by equity shareholders, they are referred to as
internal equity.
• Companies normally retain 30 percent to 80 percent of profit after tax for
financing growth.
• A Balance Sheet figure shown under the heading retained earnings is the sum
of all profits retained since the company’s inception.
• If you look at a sample of corporate balance sheets you will find that reserves
and surplus (other than share premium reserve and revaluation reserve), which
essentially represent accumulated retained earnings and are often the dominant
source of long-term finance.
 Special Financial Institutions
• Soon after independence, it was felt that fast industrial growth in the country cannot take
place without cheapening and widening channels of industrial finance. A notable step
towards this was the establishment of special financial institutions both at the national and
state level.
• National level institutions includes the Industrial Finance Corporation of India, the Industrial
Credit and Investment Corporation of India, Industrial Development Corporation of India,
Industrial Development Bank of India and Industrial Reconstruction Corporation of India.
• State level institutions include the State Financial Corporations and State Industrial
Development Corporations.
• These institutions are, mainly financing agencies, providing medium and long- term capital,
generally to the private sector. Their operations also include conducting of market surveys,
preparation of project report, provision of technical advice & management services and
establishment and management of industrial units.
• They help in the development of the capital market by providing direct financial assistance
to industrial enterprises and by helping them to raise long-term loans from the market. They
underwrite the new issues of industrial securities and also subscribe to them.
• They are working as an instrument of balanced economic development by focusing their
efforts on less developed industries and backward regions of the country.
 Sources of Short Term Finance

Trade Credit
Accrued Expenses or Outstanding Expenses
Commercial Paper
Working Capital Advance by Commercial Banks
Public Deposits
Deferred Incomes
Working Capital finance by Financial Institutions
Trade Credit
• Trade credit represents the credit extended by the suppliers of goods and services. It is a
spontaneous source of finance in the sense that it arises in the normal transactions of the
firm without specific negotiations, provided the firm is considered creditworthy by its
supplier. It is an important source of finance representing 25 percent to 50 percent of short-
term financing.
• In the normal course of business, the goods or raw materials arc purchased from suppliers
on credit. How much time is available for payment depends upon the agreement between
the two parties and varies with industry to industry practice.
• How much credit will be available depends upon the credit worthiness of the firm and the
confidence of suppliers in the firm.
Accrued Expenses or Outstanding Expenses
• Accrued expenses arc those expenses which are not paid but the benefit of which has been
taken. This is simply a liability. Wages, salaries, interest, etc. are the examples of accrued
expenses.
• Generally, employees and workers are paid after a week or fortnight or month for the
services they have provided. Similarly, the interest is paid after a specified period of time.
Greater the period, greater will he the amount as accrued expenses.
• Thus, accrued expenses become a short-term source of finance. The level of accruals
changes with the change in the level of activity of a firm. It is a free source of short-term
finance as no amount of interest is to be paid on accruals.
Commercial Paper
• Commercial paper represents short-term unsecured promissory notes issued by firms, which enjoy a fairly high
credit rating. Generally, large firms with considerable financial strength are able to issue commercial paper.
The important features of commercial paper are as follows:
 The maturity period of commercial paper ranges from 90 to 180 days.
 Commercial paper is sold at a discount from its face value and redeemed at its face value. Hence the
implicit interest rate is a function of the size of the discount and the period of maturity.
 Commercial paper is generally placed with investors who intend holding it till its maturity. Hence there is no
well developed secondary market for commercial paper.
• Commercial paper is a new instrument in money market. These were introduced to enable highly rated
corporate borrowers to diversify their sources of short-term borrowings and provide an additional instrument to
the investor. RBI has issued the guidelines to regulate the issue of commercial paper.

Working Capital Advance by Commercial Banks

• Working capital advance by commercial banks represents the most important source for financing current
assets.
• The commercial banks collect the money from the public in the form of saving account, current accounts and
term deposits and out of this collection, they finance the working capital requirements of corporate.
• The commercial banks were meeting the short-term requirements of industry and were accepting the deposits
traditionally. However, since the introduction of economic reforms, the banks are also meeting the long-term
requirements of funds.
• The commercial banks are providing funds to industry in a number of ways. These include Loans, Cash Credit,
Bank Overdraft etc.
Public Deposits
• Many firms, large and small, have solicited unsecured deposits from the public in recent
years, mainly to finance their working capital requirements.
• The interest rate payable on public deposits was subject to a ceiling till mid-1990s. Just
before the ceiling was withdrawn, it was 15 percent. Companies typically offer an interest
rate varying between 8 to 12 or even more percent depending on the tenor of the deposit.
• The regulation of public deposits underwent an overhaul with the introduction of stringent
regulations under The Companies Act 2013.
Deferred Incomes
• Deferred incomes are the incomes received in advance for which services are to be
rendered or goods are to be supplied. It is also a free short-term source of finance.
• But this source is available to only those firms whose products and services are in great
demand and can demand for advance amount.
Working Capital finance by Financial Institutions
• Financial institutions extend working capital finance on a very selective basis to
borrowers enjoying credit limits with banks, whether under a consortium or under
multiple banking arrangement, when the banks are not in a position to meet the credit
requirements of the borrowers concerned because of temporary liquidity constraints.