MGT 517 Topic: Sources of Finance

Company: Tata Steel Limited (India)

Submitted to: Mr. Sourabh Kumar Submitted by: Manhar Parmjot Singh 10900912 A56 M39B1

Table of Contents

1.0 Sources of Finance 1.1 Internal sources of finance 1.1.1 Personal savings 1.1.2 Retained profits 1.1.3 Working capital 1.1.4 Sale of fixed assets 1.2 External sources of finance 1.2.1 Ownership capital 1.2.1.1 Ordinary shares 1.2.1.2 Preference shares 1.2.2 Non-ownership capital 1.2.2.1 Debentures 1.2.2.2 Bank overdraft 1.2.2.3 Loan 1.2.2.4 Hire purchase 1.2.2.5 Lease 1.2.2.6 Grant 1.2.2.7 Venture capital 1.2.2.8 Factoring 1.2.2.9 Invoice discounting 2.0 Choosing an appropriate source of finance 2.1 The amount of money needed 2.2 The urgency of funds 2.3 The cost of the source of finance 2.4 The risk involved 2.5 The duration of finance 2.6 The gearing ratio of the business 2.7 The control of the business 3.0 The impact of several sources of finance on the financial statements 4.0 Tata Steel Limited 5.0 Identifying sources of finance in Tata Steel balance sheet. (In Rs. cores) 6.0 Conclusion

1.0 Sources of Finance

Finance is essential for a business's operation, development and expansion. Finance is the core limiting factor for most businesses and therefore it is crucial for businesses to manage their financial resources properly. Finance is available to a business from a variety of sources both internal and external. It is also crucial for businesses to choose the most appropriate source of finance for its several needs as different sources have its own benefits and costs. Sources of financed can be classified based on a number of factors. They can be classified as Internal and External, Short-term and Long-term or Equity and Debt. It would be convenient to classify the sources as internal and external.

1.1 Internal sources of finance

Internal sources of finance are the funds readily available within the organization. Internal sources of finance consist of: Personal savings Retained profits Working capital Sale of fixed assets 1.1.1 Personal savings This is the amount of personal money an owner, partner or shareholder of a business has at his disposal to do whatever he wants. When a business seeks to borrow the personal money of a shareholder, partner or owner for a business's financial needs, the source of finance is known as personal savings. 1.1.2 Retained profits Retained profits are the undistributed profits of a company. Not all the profits made by a company are distributed as dividends to its shareholders. The remainder of the profits after all payments are made for a trading year is known as retained profits. This remainder of finance is saved by the business as a back-up, in times of financial needs and maybe used later for a company's development or expansion. Retained profits are very valuable, no-cost source of finance. 1.1.3 Working capital Working capital refers to the sum of money that a business uses for its daily activities. Working capital is the difference of current assets and current liabilities (i.e. Working capital = Current assets - Current liabilities). Proper working capital management is also vital as it is also a source of finance for a business. Current assets Current assets are also known as cash equivalents because they are easily convertible to cash. Current assets consist of Stock, Debtors, Pre-payments, Bank and Cash. These assets are used up, sold or keep changing in the short run. Stock - this refers to the stock of goods available to the business for sale at a given time. It is very important to maintain the right amount of stock of goods for a business. If stock levels

are too high it means that too much of money is being held up in the form of stock and if stock levels are too low the business will lose possible opportunities of higher sales. Debtors These are business's customers owing money to the business having been bought the business's goods or service on credit. If a business has cash flow problems it can maintain a low level of debtors by encouraging the debtors to pay as early as possible. Prepayments - these are the expenses paid in advance. The payment being made even before the expense occurs is a prepayment. Bank and Cash - Bank money is the cash held in banks and cash is money held by the business in the form of cash in hand. Having too much of money in the form of cash is also not good for a business since that money can be used to invest and earn a return but however a business should have healthy current ratio (current assets : current liabilities) of 2:1. Current liabilities Current liabilities are short-term debts that are in immediate need of settlement. Some examples of current liabilities are creditors, accruals, proposed dividends and tax owing. These obligations have to be paid within a year. Creditors - also known as trade creditors are suppliers from whom the business purchased goods on credit. Paying the creditors as late as possible will ease cash flow requirements for a business. Accruals - are the expenses owed by the business. Dividends proposed - are the dividends payable for the year that is not yet paid. Tax owing - is the sum of money owing as tax. 1.1.4 Sale of fixed assets Fixed assets are those assets, which a company does not consume in the process of production. Some examples of fixed assets are land and building, machinery, vehicles, fixtures and fittings and equipment. Sometimes where the fixed asset is surplus and is abandoned, it can be sold to raise finance in demanding times for the business. Otherwise businesses may choose to stop offering certain products and sell its fixed assets to raise finance. Selling fixed assets reduces the production capacity of a business, affecting a business's return.

1.2 External sources of finance

Sources of finance that are not internal sources of finance are external sources of finance. External sources of finance are from sources that are outside the business. External sources of finance can either be: Ownership capital Non-ownership capital

1.2.1 Ownership capital

Ownership capital is the money invested in the business by the owners themselves. It can be the capital funding by owners and partners or it can also be share, bought by the shareholders

of a company. There are mainly two main types of shares: Ordinary shares Preference shares 1.2.1.1 Ordinary shares Ordinary shares, also known as equity shares, are a unit of investment in a company. Ordinary shareholders have the privilege of receiving a part of company profits via dividends which is based on the value of shares held by the shareholder and the profit made for the year by the company. They also have the right to vote at general meetings of the company. Companies can issue ordinary shares in order to raise finance for long-term financial needs. 1.2.1.2 Preference shares Preference shares are another type of shares. Preference shareholders receive a fixed rate of dividends, before the ordinary shareholders are paid. Preference shareholders do not have the right to vote at general meetings of the company. Preference shares are also an ownership capital source of finance. There are several types of preference shares. Some of them are Cumulative preference share, Redeemable preference share, Participating preference share and Convertible preference share. Cumulative preference shares - if a company is in loss making situation and is unable to pay dividends for one year then the dividend for that year will be paid the next year along with next year's dividends. Redeemable preference shares - these preference shares can be bought back by the company at a later date. Normally the date of redemption is usually agreed. Participating preference shares - give the benefit of additional dividends to its shareholders above the fixed rate of dividends they receive. The additional dividend is usually paid in proportion to ordinary dividends declared. Convertible preference shares - convertible preference shareholders have the option of converting their preference shares to ordinary shares.

1.2.2 Non-ownership capital

Unlike ownership capital, non-ownership capital does not allow the lender to participate in profit-sharing or to influence how the business is run. The main obligations of non-ownership capital are to pay back the borrowed sum of money and interest. Different types of non ownership capital: Debentures Bank overdraft Loan Hire-purchase Lease Grant Venture capital Factoring Invoice discounting

1.2.2.1 Debentures Debentures are promissory notes, issued in order to raise debt capital. Debenture holders are not owners but long-term creditors of the company. Debenture holders receive a fixed rate of interest annually whether the company makes a profit or loss. Debentures are issued only for a time period and thus the company must pay the amount back to the debenture holders at the end of the agreed period. Debentures can be secured, unsecured, fixed or floating. Secured debentures - are debentures that are secured against an asset. They are also called mortgage debentures. Unsecured debentures - these debentures do not have an asset as collateral. Fixed debentures - have a fixed rate of interest. Floating debentures - do not have fixed rate of interest and are not tied to any specific asset. Bearer debentures - these debentures are easily transferable. Registered debentures - are not easily transferable and legal procedures have to be followed in case of a transfer. Convertible debentures - can be converted to stock at the end of the debenture repayment date. 1.2.2.2 Bank overdraft Bank overdraft is a short term credit facility provided by banks for its current account holders. This facility allows businesses to withdraw more money than their bank account balances hold. Interest has to be paid on the amount overdrawn. Bank overdraft is the ideal source of finance for short-term cash flow problems. 1.2.2.3 Loan Loans are amounts of money borrowed from banks or other financial institutions for large and long-term business projects such as the development or expansion of the business. However loans can be substituted by other alternative sources of finance which are more suitable. 1.2.2.4 Hire purchase Hire purchase allows a business to use an asset without paying the full amount to purchase the asset. The hire purchase firm buys the asset on behalf of the business and gives the business the sole usage of the asset. The business on its part must pay monthly payments to the hire purchase firm amounting to the total value of the asset and charges of the hire purchase firm. At the end of the payment period the business has the option of purchasing the asset for a nominal value. 1.2.2.5 Lease In a lease the leasing company buys the asset on behalf of the business and the asset is then provided for the business to its use. Unlike a hire purchase, the ownership of the asset remains with the leasing company. The business pays a rent throughout the leasing period. The leasing firm is known as the leaser and the customer as lessee. Leasing is of two types, namely Finance lease and Operating lease. Finance Lease - this is where the lessee's monthly payments add up to at least 90% of the total value of the asset. Operating Lease - this lease does not run for the full life of the asset and the lessee is not liable for the full value of the asset. The residual risk is taken up by the leaser.

1.2.2.6 Grant Grants are funding given to businesses for programs or services that benefit the community or public at large. Grants can be given by the government or private firms. For example, a grant may be given to open a new factory where unemployment is high. 1.2.2.7 Venture capital Venture capital is the capital that is contributed at the initial stages of an uncertain business. The chance of failure of the business is great while there is also a possibility of providing higher than average return for the investor. The investor expects to have some influence over the business. 1.2.2.8 Factoring This is where the factoring company pays a proportion of the sales invoice of the business within a short time-frame to the business. The remainder of the money is paid to the business when the factoring company receives the money from the business's debtor. The remainder of the money will be paid only after deducting the factoring company's service charges. Some factoring companies even offer to maintain the sales ledger of the business. Factoring is of two types: Recourse factoring and Non-recourse factoring. Recourse factoring - In this type of factoring the client company is liable for bad debts. Non-recourse factoring - is where the factor takes responsibility for the payment of the debtors. The client company is not liable if debtors do not pay back. Non-recourse factoring is usually more expensive because of the high risks experienced by the factor. 1.2.2.9 Invoice discounting In invoice discounting the client company send out a copy of the invoice to the invoice discounting firm. The client then receives a portion of the invoice value. In contrast to factoring, the client company collects the money from its debtors. Once the pa yment is received it is deposited in a bank account controlled by the invoice discounter. The invoice discounter will then pay the remainder of the invoice less any charges to the client.

2.0 Choosing an appropriate source of finance

There are many sources of finance available to a business. Finance is needed for several purposes and different purposes need sources of finance, which are most suitable to them. When choosing an appropriate source of finance some factors have to be considered. The factors that need to be considered when choosing an appropriate source of finance are: The amount of money needed The urgency of funds The cost of the source of finance The risk involved The duration of finance The gearing ratio of the business The control of the business

2.1 The amount of money needed This is the amount of finance, the organization wants to raise. Not all sources of finance provide all amounts of funds. Some sources are not able to raise large amounts of funds whereas others are not flexible enough to put up for the small sum of money the business requires. Therefore it is necessary to identify the amount of money needed by the company to choose a suitable source of finance. For example borrowing a commercial loan for a small and short-term cash flow problem is unwise because loans may have a minimum amount that can be borrowed so taking a bank overdraft would be wise where money can be borrowed in small sums and bank overdr afts can be paid back quickly. Therefore the amount of money required is a key factor in choosing a source of finance. 2.2 The urgency of funds This refers to the amount of time the business can spend on collecting funds. If the business has plenty of time before its financial needs, need to be met then it can spend time searching for cheap alternatives of sources of finance. On the other hand if the business wants the money as soon as possible then it would have to make some cost sacrifices and accept a source of finance that may even cost higher. The urgency of funds needs to be identified also because certain sources of finance need more time to be raised than other sources of finance. For example issuing shares is a very long and complex process where there are legal requirements and then the potential shareholders have to be informed (advertising) and after all these the money is collected through the process of application and allotment which takes more time. 2.3 The cost of the source of finance Different sources of finance have different costs as discussed above. It is always more profitable to a business to seek and obtain cheaper sources of finance. Sometimes however the time does not permit organizations to look for cheaper sources of funds. Internal sources of finance are always cheaper than external sources of finance. 2.4 The risk involved The risk involved is the certainty of receiving returns for the lender on the investment made using the finance. In simpler words it is the sureness of success of the project. If the provider of finance is not confident that the project in which his money is invested in is less likely to reap returns then the lender would be reluctant to provide the business with funds. In this case the money can be secured against an asset as collateral which will encourage the lender to lend.

2.5 The duration of finance This is the time period for which the money is needed. It can be for a short-term (within one year), medium-term (one to five years) or long- term (five years and more) time period. By identifying the length of requirement of finance the organization can eliminate inappropriate sources of finance and choose a source of finance that is more suitable for the required timeframe.

2.6 The gearing ratio of the business The gearing ratio plays an important role in the availability of the sources of finance since the gearing ratio shows the ratio of debt capital to the total capital of a business. If a business is high geared then commercial lenders will be unwilling to give loans because the business is already operating on more loans than equity capital. A high geared company will have to pay more of its profits as interests on loans and other debt capital. That being the case potential lenders fears the business' ability to be able to cope with more interest payments and debt settlement. 2.7 The control of the business The existing shareholders of a company would be reluctant to issue shares because this would cause a dilution in control of the business. Issuing shares in public limited companies also gives opportunity of takeovers to outside parties. The same can be said for venture capitalists where the money is invested as equity and being owners the venture capitalists have the right to influence how the business is run. The existing shareholders and owners of a business who would not want any change to arise in the control and ownership of the business would disregard sources of equity finance.

3.0 The impact of several sources of finance on the financial statements

Financial statements keep record of a business's trading year (Trading, profit and loss account) and show the financial position of a business as at a date (Balance sheet). Obtaining finance from different sources bring about a change in the financial statements. This portion investigates how each source of finance is recorded and affects the financial statements. Personal savings Personal savings when lent to the business are considered as loans. The amount lent will appear as Long-term liabilities on the balance sheet. If any interest payments are to be made they will be recorded in the profit and loss account and charged against profits. Sale of assets Sale of assets will reduce the value of fixed assets on the balance sheet. The profit or loss made on the sale of asset will be recorded in the profit and loss account for the year. The depreciation of the asset along with its original price will be removed from the balance sheet. Ordinary shares and preference shares The issue of ordinary shares and preference shares increase the value of equity capital in the balance sheet. If the market price of issued shares is greater than the nominal value of the share then share premium is also increased in the balance sheet. The number of shares issued is also displayed in the balance sheet and for preference shares the rate of dividend is also shown. The dividends paid to the shareholders are recorded in the appropriation account after tax is deducted from net profit. Debentures Debentures are a type of debt capital. The value of debentures along with the rate of interest and the repayment date is presented in the equity and liabilities section of the balance sheet. The interest paid on debentures is reduced from profits before tax is charged.

Bank overdraft This appears in the balance sheet as a current liability since it is a short-term debt and has to be paid back within a year. The interest charges and bank overdraft fee if charged are deducted from the profit and loss account before tax is charged. Loan Loans are long-term debts and therefore come under long-term liabilities in a balance sheet. The loan when displayed on a balance sheet will usually contain information about the repayment date and the interest charged on the loan. The interest is charged in the profit and loss account. Venture capital This is an amount of money invested in the business as equity capital and thus comes under equity capital in the balance sheet. The return for venture capitalists is a share of profits which is recorded in the appropriation account. Factoring and invoice discounting This does not appear in the balance sheet. However the money received from factoring and invoice discounting can show higher balances of cash. The interest charges and fee is recorded in the profit and loss account.

4.0 Tata Steel Limited

Established in 1907, Tata Steel is among the top ten global steel companies with an annual crude steel capacity of over 28 million tonnes per annum (mtpa). It is now one of the world's most geographically-diversified steel producers, with operations in 26 countries and a commercial presence in over 50 countries. The Tata Steel Group, with a turnover of US$ 26.13 billion in FY 2011- 2012, has over 81,000 employees across five continents and is a Fortune 500 company. Tata Steels vision is to be the worlds steel industry benchmark through the excellence of its people, its innovative approach and overall conduct. Underpinning this vision is a performance culture committed to aspiration targets, safety and social responsibility, continuous improvement, openness and transparency. Tata Steels larger production facilities include those in India, the UK, the Netherlands, Thailand, Singapore, China and Australia. Operating companies within the Group include Tata Steel Limited (India), Tata Steel Europe Limited (formerly Corus), NatSteel, and Tata Steel Thailand (formerly Millennium Steel). Given below is Tata Steel Limiteds balance sheet.

5.0 Identifying sources of finance in Tata Steel balance sheet. (In Rs. crores)

Fixed assets that can be sold are potential sources of finance that is categorized as sales of assets = 27,424.75

Working capital is current assets minus current liabilities Working capital = (12,864.50 16,903.64) = - 4,039.14 Reserve and surplus are the accumulated earnings of a company = 51,649.95 Share capital = 971.41 Long Term borrowings = 21,353.20

6.0 Conclusion
Sources of finance is available from variety of sources but each source has its own cost and benefits. It is important to choose an appropriate and cheap source of finance for the smooth operation of the firm. There are important factors to consider when choosing a source of finance.