Sources of Finance Finance

Sources of Finance:
Broadly, various sources of finance can be categorized as follows

Chapter 3- Sources of Finance

A Joint Stock Company may raise finance from many sources. These sources are broadly classified into two categories:
Long Term Sources Short Term Sources
Equity Shares Commercial Banks
Preference Shares Public Deposits
Debentures Trade Credit
Loans From Commercial Banks Customer Advance
Loans From Financial Institutions Factoring
Retained Earnings Installment Credit
Inter-Corporate Finance

Long Term Sources : Sources through which funds are raised for long term use in the business are termed as long
sources. These are explained as below:
Shares: Funds raised from Issue of shares constitute the Ownership Fund of the company. Those who invest in shares are known as
shareholders. A public company can issue two types of shares:
1. Equity Shares
2. Preference Shares
3. EQUITY SHARES
They are the real owners of the company. Full voting rights are guaranteed to equity shareholders. They participate in the meetings of the
shareholders, elect directors and approve major changes in the policies and programmes of the company. Equity shares are listed at the stock
exchange and are freely transferable.
The rate of dividend is not fixed. It is decided by the board of directors on the basis of profits left after making payments of preference shares
dividend. Therefore, the investors bear the maximum risk but may enjoy the maximum profits if the company’s performance is good.
The main features of Equity Shares are as follows:
1. Risk Bearing: Equity Shareholders bear the maximum risk in the company as they get dividend at the last. The investment is only returned only
on winding up of the company and that too after paying all other liabilities.
2. Voting Rights: Equity shareholders have voting rights. All important decisions are taken in the general meeting and extraordinary
meetings of a company, in which only equity shareholders have right to attend.
3. Dividend: The rate of dividend is not fixed. It is decided in based on the profits available. In case the company does not earn profit, no dividend
is paid on equity shares.
4. Capital Appreciation: Equity shares are listed at the stock exchange and there is possibility of capital appreciation in the prices of shareholders.
They can also sell the shares, in case they want to leave the company.
Advantages of Equity Shares
A.) From the company point of view
1. Permanent capital – The funds raised through issue of equity shares is permanent capital for the company. It is not required to be refunded
during the lifetime of the company. This amount is mostly used to generate fixed assets of the company.
2. No charge on assets – A company is not required to mortgage or create a charge on the assets of the company for raising funds through issue
of equity shares.
3. No burden on profits – It is not obligatory on the part of the company to pay dividend on equity shares in case the profits are not sufficient
or the company decides to retain profits for expansion or modernization.
4. Source of strength – Equity share capital reflects the strength of the company because it is used for fixed assets and does not create burden
for its repayment or payment of dividend on regular basis.
5. Large funds – Equity shares have a small nominal value (say Rs.10 per share). It encourages the investors to invest in equity shares. There is
no limit of number of members in a public company. Therefore, a large number of persons invest in equity shares and the company will be in a
position to collect huge amount of money through equity shares.
B.) From the shareholder point of view
1. Voting rights – Equity shareholders have full voting rights and participate in the meetings of shareholders. They elect directors and approve
major policy changes.
2. Higher dividend – The rate of dividend on equity shares is not fixed. It depends upon profits, in case the earnings of the company are good,
the directors recommend high rate of dividend.
3. Capital appreciation – Equity shares are listed at the stock exchange and the prices of shares go up in case the performance of the company
has been good and the market conditions are also favourable.
5. Bonus shares and Right shares – Bonus shares and Right shares are issued only to the equity shareholders.
5. Higher Liquidity: Equity shares are traded at the stock exchanges. So, it provides higher liquidity to investors. They can sell the shares
whenever, they are in need of money.
Disadvantages of Equity Shares
A.) From the company point of view
1. Manipulation of control – The management of the company may be manipulated by few shareholders to maintain the control of the
company in their own hands. Sometimes, they may not work in the interest of the company.
2. Overcapitalisation – The funds raised through equity shares are not returned during the lifetime of the company. Sometimes, more
capital is raised than required which results in overcapitalisation. It reduces earnings per share.
3. No benefit of trading on equity – If all the funds are raised through equity shares, the company will not be able to take advantage of
trading on equity.
4. Costly – The cost of raising funds through issue of equity shares is high. A lot of money is spend on underwriting commission, brokerage
and other expenses.
B.) From the shareholders point of view
1. High risk – Equity shareholders bear the maximum risk. They are the last to get return on their investment, i.e., dividend and the capital
when the company is closed.
2. Uncertainty of dividend – Dividend on equity shares is paid only out of profits. In case, the profits are not sufficient, no dividend is paid.
3. Concentration of power in few hands – Some shareholders keep the control of the company in their own hands by holding majority
shares. Therefore, small investors may remain at the mercy of such shareholders.
4. Unhealthy speculation – The stock market fluctuates wildly because of speculations by few operators. The management of the company
may also indulge into such activities which causes extensive loss to the innocent investors.
PREFERENCE SHARES
These are those types of shares on which a fixed rate of dividend is paid, and
1. Dividend on preference shares is paid in priority to equity shares dividend, i.e., the preference dividend is paid before dividend is paid on
equity shares.
2. Return of Capital: Preference share capital is paid back (returned) in priority to equity share capital in the event of or at the time of
winding up (closing of) of the company.
Features/characteristics of Preference Shares
1. A fixed rate of dividend is paid on preference shares.
2. The preference shareholders have preference in getting the dividend. It is paid in priority to equity share dividend.
3. The preference share capital is returned in priority to equity share capital, if the company is closed.
4. Preference shareholders do not have voting rights and cannot take part in the meetings of the shareholders.
5. A company can issue different kinds of preference shares, like redeemable, non-redeemable, commulative or non-commulative shares,
etc.
Types of Preference shares
1. Cumulative preference shares – These preference shares have a right to get dividend out of the profits and in case the profits are
insufficient, the dividend is to be carried forward and paid out of the future profits.
Non-cumulative preference shares – Dividend on such shares is paid only out of the current year’s profit and in case the profits are not
sufficient, no dividend is to be paid and the preference shareholders do not have the right to get the ‘arrears’ (past unpaid amount) of dividend
in the future.
2. Redeemable preference shares – Such shares are redeemed (paid back) after a fixed period of time and the preference share capital is
returned to the shareholders.
Irredeemable preference shares – The amount raised from such shares is not redeemed during the lifetime of the company and is to be paid
back only after the winding up of the company.
3. Convertible preference shares – Those preference shares which are given the right or option to get their shares converted into equity
shares after a fixed period of time, are known as convertible preference shares.
Non-convertible preference shares – Those preference shares which are not convertible into equity shares, are known as non-convertible
preference shares.
 4. Participating preference shares – These are those preference shares on which the investors have the right to participate in the surplus
profits left after paying all dividends (i.e., preference share dividend as well as dividend on equity shares).
Non-participating preference shares – Only a fixed rate of dividend is paid on these shares and there is no right to participate in the surplus
profits.

Advantages of preference shares

A.) From the point of view of the company
1. Appeal to cautious investors – A company is able to raise funds from those investors, who want more security and stability or regularity in
their earnings as compared to equity shares.
2. No interference in management – Preference shareholders do not have voting rights, therefore, the shareholders are not allowed to
interfere in the management and decisions of the company.
3. No charge on assets – A company is not required to create a charge on the assets of the company. Therefore, the assets can be used for
raising loans in the future.
4. Trading on equity – The rate of dividend payable on preference shares is fixed. When the earnings of the company are good, a higher rate of
dividend can be paid on equity shares.
5. No burden on profits – There is no obligation on the company to pay dividend in case of insufficient profits or when there are losses in the
company.
6. Flexibility – A company can maintain flexibility in its capital structure by issuing redeemable preference shares.
B.) From the point of view of the investors (Preference shareholders)
1. Stable and regular dividend – There is a higher possibility of getting stable and regular dividend because preference dividend is paid before
the equity share dividend.
2. Less risk – Preference shares are less risky as compared to equity shares because there is no fluctuation in the prices of shares and there is
better security to their investment as compared to equity shares.
3. Redemption – Most of the preference shares are redeemable after a fixed period of time. Therefore, the investors can get back their
investment from the company.
4. Cummulative Dividend – In case of cummulative preference shares, the dividend is carried forward and the arrears are paid out of the future
profits.

Disadvantages of Preference Share

A.) From the point of view of the company
1. Low appeal – Preference shares have a very low appeal to the investors. A cautious investor prefers debentures than preference shares.
2. Permanent burden – There is a permanent burden on the company to pay dividend on cumulative preference shares
3. More legal formalities – A company has to follow a number of legal formalities when preference shares are to be redeemed
4. Costly – The dividend on preference shares cannot be treated as business expense, therefore, the company has to pay higher rate of tax.
B.) From the point of view of the investors
1. No voting rights – Preference shareholders cannot participate in the meetings of the shareholders.
2. No capital appreciation – Preference shares are not listed at the stock exchange, therefore, there is no possibility of increase of capital
appreciation of preference shares.
3. No guarantee of dividend – Dividend on preference shares is paid only out of profits. In case a company continues to suffer losses, no
dividend will be paid even on preference shares.
4. Fear of being shown the door – Preference shares are redeemable. A company has the option to pay back the preference share capital in
case it has surplus funds.

DEBENTURES:
MEANING:- Debentures represent borrowed fund and is a loan capital. Debenture holders are the creditors of the company.
Debenture is a document or a certificate issued by the company as an acknowledgement of debt.
Interest on debentures is paid at a fixed rate. Debentures carry no voting rights but they generally involve a charge on the assets of the
company.

CHARACTERSTICS:-
a) Debentures represent borrowed fund.
b) A fixed rate of interest is paid on debentures.
c) Interest is payable every year irrespective whether there are profits or not.
d) Debentures generally carry no voting rights.
e) Debentures generally involve a charge on the assets of the company.
f) Debentures are generally redeemable and repayable after a fixed period of time.

KINDS OF DEBENUTES:- Debentures are of the following types:-

1. Registered debentures: - Registered debentures are those which are recoded in the Register of Debenture-holders maintained by the
company with full details as to number, value and type of debentures held by each debenture-holder. Registered debentures cannot be
transferred by mere delivery. Such debentures can be transferred only by transfer deed or intimation to the company. The transfer of such
debentures is recorded in the register of the company. A new debenture certificate is issued to the buyer and name of seller of debentures is
cancelled. The payment of interest and repayment of debenture money is made to those debenture-holders whose names are registered with
the company.
 2. Bearer Debentures:- These are those debentures which are transferable by mere delivery. It is not necessary to inform the company
about the transfer. Interest is paid on the production of coupons attached to such debentures. No register is maintained for bearer debentures.
3. Secured or Mortgaged debentures:- Debentures which are secured by a charge on the assets of the company, are known as secured
debentures. In case the company fails to the loan amount or the interest on time, these debenture-holders have the right to recover their
principal amounts, as well as the unpaid interest, out of assets mortgaged by the company.
The charge on assets are of two types:
 Fixed Charge ,
 Floating Charge
When the charge is given on some specific assets, it is known as fixed charge.
When the assets in general are give by way of security, it is known as a floating charge.
4. Unsecured/naked/simple debentures:- Such debentures are unsecured and do not create any charge on the assets of the company.
In case of default in the payment of interest or the principal amount, the debenture-holders can only file a case for the recovery of money and
they will be ranked along with other unsecured creditors of the company.
5. Redeemable debentures:- These are those debentures which are redeemed (paid back) after a fixed period of time. The time of
redemption is fixed at the time of issue. All debentures are redeemable unless otherwise specified.
6. Irredeemable debentures:- These are those debentures which are not redeemed during the lifetime of the company. It is part of the
permanent capital of the company. Such debt becomes due for payment only when the company goes into liquidation.
7. Convertible debentures:- In case an option is given to the debenture holders to convert their debentures into equity shares after the
lapse of a specified period, these are called convertible debentures. It provides a privilege to the investors to change their status from creditors
to the owners.
8. Non-convertible debentures: All debentures are non-convertible unless there is an option of conversion into equity shares.
ADVANTAGES OF ISSUING DEBENTURES
A) Advantages from the point of view of Company:-
i) Economical source: The cost of raising funds through debentures is relatively lower. This is because it is a safer investment and
the investors are ready to invest in debentures. The rate of interest on debentures is also lower than the interest charged by banks on loans.
Underwriting commission, brokerage and other expenses of issue are lesser.
ii) No Interference in management: Debentures do not carry voting right. Therefore, they cannot interfere in management. The existing
shareholders can continue control of the company.
iii) Trading on equity: Interest on debentures is paid at a fixed rate. In case the earnings of the company increase, the rate of dividend on
equity shares can be increased. The policy of raising a fixed income security with an objective of increasing dividend on shares is called trading
on equity.
iv) Flexibility: A company can repay the funds raised through debentures when it does not require the funds any more. This facility of
redemption avoids danger of over-Capitalisation. It keeps the financial structure flexible.
v) Tax relief: Interest on debentures is allowed to be treated as a business expense. Hence, it reduces the net profit on which tax is to
be imposed. It results in saving in income tax liability.

B) Advantages from the point of view of debenture-holders:

i) Fixed and regular return: The debenture-holders and paid a fixed rate of return at regular interval irrespective of profits.
ii) Security of investment: Debentures are usually secured by a charge on the assets of the company. This ensures safety of investment
in debentures, as their repayment is assured.
iii)Appeal to cautious investors: Debentures is a good option for those investors who are cautious an orthodox. Safety of investment and
fixed rate of return attract such investors.
iv) Stable Prices: Prices of investment in debentures is always fixed and stable. Debentures are not speculated as shares.

DISADVANTAGES of Debentures –
A) From the company point of view:
i) Permanent burden of interest: A company has to pay interest on debentures irrespective of the financial condition or profits of the
company. It becomes a heavy burden during depression and bad days for the company.
ii) Charge on assets: the assets of the company are usually mortgaged with debenture-holders as a security. This lowers the ability of
the company to raise funds from banks and financial institutions.
iii)Reduction in dividend: In case the financial structure of the company is heavily loaded with debentures, a large part of the earnings of the
company will be paid in the form of interest on debentures. In case of low earnings, very little profit might be left for the shareholders. The
market value of its shares may go down.

B) Disadvantages from the point of view of Debenture-holders:-

i) No voting rights: Debenture-holders have no voting rights and cannot take part in management. Therefore they remain at the mercy
of shareholders.
ii) High unit price: The price per debenture is much higher as compared to shares. Therefore, small investors may not be able to
purchase debentures.
iii) Unattractive: Debentures do not appeal much to the adventurous investors who want a high return and appreciation of capital.
Difference between Shares and Debentures:

S.No. Basis of
Shares Debentures
difference
 1. Status of holders. Share-holders are the owners of the Debenture-holders are the
company. creditors.

2 Yield( reward for Dividend is paid on shares only Debenture-holders are paid
investment) when the company earns profits. interest irrespective of profits.

3. Nature of return Rate of Dividend fluctuates with Rate if interest is fixed and
profits on equity shares but is fixed regular on debentures.
on preference shares.

Security No security. Shares are issued Secured. Debentures are

4. without any charge or mortgage on normally against the security
assets. of certain assets.

Voting rights Equity shares carry voting rights

5. and participate in the management Debenture holders do not
of the company. have any voting rights.

Not redeemable except redeemable Redeemable after a certain

6. Redemption preference shares. period.

Order of The share capital is repaid in the Debenture money is paid in

7. repayment on last. priority to equity shares.
winding up.

8. Convertibility Shares can not be converted into Convertible debentures can

debentures. be converted into shares

Tax benefit Dividend on shares in not an Interest is an expense, reduce

9. expense and does not reduce tax profits and the tax liability.
liability of the company

PUBLIC DEPOSITS

Non-banking companies are allowed to raise money from the public including employees and shareholders. It is a kind of unsecured loan and
the assets of the company are not required to be mortgaged for accepting deposits from public. Public deposits can be accepted for a
period not less than six months, but not exceeding three years at a time. Depositors get a fixed rate of interest which is usually more than that
available on bank deposits. At the same time, companies find it cheaper than loans from banks and financial institutions.
Advantages :-
1. No legal formalities : It is a simple method, where public make deposits at their free will. It involves no legal formalities which are required in
the issue of shares and debentures.
2. No charge on assets : Public deposits do not involve any charge on the assets of the company. The company can use its fixed assets for
raising funds from other sources.
3. No interference in management: Depositors do not have any voting rights. They can not take part in management and do not interfere in the
matters of the company.
4. Flexibility in capital structure: The capital structure of the company can be kept flexible by this method of finance. Fixed deposits can be
returned if the company is overcapitalized. On the other hand, additional finance can be raised without much difficulty, in case of need.
5. Economical : It is economical because the rate of interest allowed on deposits is usually less than the interest rate charged by banks and other
financial intuitions on loans.
6. Trading on equity: Interest on Deposits is paid at a fixed rate. In case the earnings of the company good, the rate of dividend on equity shares
can be increased.
DISADVANTAGES:-
1. Unsuitable for new concerns: This method is not suitable for new companies as the public may be hesitant to invest for fear of loss of money.
2. Uncertainty of getting deposits: Public deposits are called “fair weather friends”. There is no certainty of getting a good response from public
particularly in period of depression.
3. Unsecured: Depositors face high risk as public deposits are secured on the assets of the company.
4. Restrict growth of capital market: Public deposit hamper the grown the healthy capital market in the country. Widespread use such a source
may create shortage of industrial security. It may also pose a threat to the credit planning and plan priorities of the Govt.
5. Possibility of cheating( speculations): It is possible that a company may project a good picture to attract public deposits. The funds
procured may be misused and thereby innocent investors may be cheated.
6. Loss of creditworthiness: If the deposit money is not paid on maturity on account of shortage of liquid resources, the goodwill of the
company may be adversely affected.

Ploughing back of Profits (Retained Profits)

Meaning. That portion of profits which is not distributed but is retained and reinvested in the business is known as retained profits. The
retained profits are an internal source of finance. This method is also known as reinvestment of profits or Ploughing back of profits or self-
financing or internal financing.
Under this method of financing, a certain proportion of profits is transferred to reserves which are shown under the heading ‘Reserves
and surplus’
Since retained earnings actually belong to the shareholders of the company, these are treated as part of shareholders funds.
Use-The retained earnings may be used to meet long-term, medium-term and short-term financial needs of the company. Therefore
retained earnings can be used by the company for the following purposes (Need) :-
1. For the replacement of old assets which have become obsolete.
2. For the expansion and growth of the business.
3. For contributing towards the fixed as well as working capital of the company.
4. For making the company self-dependent for finances.
5. For redemption of loans and debentures.
Main Features of retained earnings are as follows:
1. Undistributed Profits: Retained earnings are profits which are undistributed for kept in the company for the purpose of expansion
or internal use.
2. Internal Source of Finance : Retained earnings are an internal source of finance.
3. Part of Owner’s Fund: Retained Earnings are part of Owner’s Fund. It is shown under the head Shareholders Funds along with share
capital in the Balance Sheet.
Merits:-
Advantages from the point of Company:
1. A Cushion to absorb the shock of economy. A policy of Ploughing back of profits acts as a cushion to absorb the shocks of economy
and business such as depression, trade cycles and uncertainty of the market with comfort, preparedness.
2. Economical method of financing: - It is economical because the company does not have to pay any interest or return the funds. It
does not have to depend upon outsiders for raising funds required for expansion, or growth.
3. Helps in following stable dividend policy:- Ploughing back of profits enables a company to follow stable dividend policy. Stability of
dividend means payment of dividend regularly and a company which ploughs back its profits can easily pay stable dividends even in the years
when there are insufficient profits.
4. Makes the company self- dependent: - A company which plough back its profits does not have to depend upon outsiders such as
banks, financial institutions, debentures etc for additional funds.
5. No Dilution of control:- A company having sufficient reserves of profits need not issue fresh shares and the present shareholders
will be in a position to retain the control of the company in their own hands. Thus the control of the existing shareholders will not be diluted
6. Improve Public Image: A company which has accumulated reserves and surplus is viewed as a good company. Increased public
image helps a company to raise funds, whenever it needs.

Advantages from the point of Company:

1. Safety of investment: Retained earnings increase financial strength of the company. This will provide safety of funds to the shareholders.
2. Stable Dividend : Retained earnings may be used for paying dividend in those years in which a company may fail to earn good profit. Thus,
shareholders may get regular dividend.
3. Issue of Bonus Shares: Retained earnings may be used to issue bonus shares. These are allotted free of cost to the shareholders.
4. Appreciation in the value of shares:- Retained earnings reflect financial strength of the company. It is viewed very positively by the investors
community. As a result, the prices of shares may rise in the long run.
7. Enables to redeem long term liabilities:- It enables the company to redeem certain long-term liabilities such as debentures and thus relieves
the company from the burden of fixed interest commitments(burden)

Demerits: -
A ) From the point of Company:
1. Over-Capitalisation: - It means more capital than actually required. Excessive Ploughing back of profits may lead to Over-Capitalisation. This
may lower the rate of return on the capital employed.
2. Concentration of Economic Power: Companies, which retain earnings may indulge in acquire other companies through the stock market and
grow disproptionally.
3. Creation of Monopolies:- Continuous re-investment of earnings may lead a company to grow into monopoly with all its evils. The company may
expand to such limits that it may control the major part of the market, which may not be in the interest of the public at large.
4. Misuse of retained earnings:- Management may not utilize the retained earnings to the advantage of shareholders at large as they have the
tendency to misuse the retained earnings by investing them in unprofitable areas.
B) From the point of Shareholders:

1. Depriving the investors of higher dividends:- The policy of Ploughing back of profits reduces the amount of dividends payable to shareholders
and this may frustrate the shareholders as they are deprived of higher dividend.
2. Manipulation in the value of shares:- The management of the company(directors) may indulge in wrong practices. When profits are retained,
the rate of dividend reduces, which may lower the value of shares in the market. They purchase the shares in the market at that time and in the
subsequent years when higher dividends are declared, such shares are sold at higher prices and earn profits at the cost of ordinary
shareholders.

The following topics are to be done from the Book

1. Loans from Banks and Financial Institutions:
2. Bonus Shares
3. Right Shares
4. Employees Stock Option Scheme
5. Sweat Equity Shares

Sources of Short Term Finance

1. Public Deposits:
 It refers to the deposits accepted from the public on which a fixed rate of interest is paid. The rate of
interest is higher than rate of interest paid by banks on their deposits.

 Only Public Companies and non-banking companies are allowed to accept public deposits. A private company is not
allowed to accept deposits.

 The time period of such deposits may range from 6 months to 3 years.

 Such deposits are unsecured and no assets are required to be pledged.

Advantages :
1. No legal formalities : It is a simple method, where public make deposits at their free will. It involves no legal formalities
which are required in the issue of shares and debentures.
2. No charge on assets : Public deposits do not involve any charge on the assets of the company. The company can use its
fixed assets for raising funds from other sources.
3. No interference in management: Depositors do not have any voting rights. They can not take part in management
and do not interfere in the matters of the company.
4. Flexibility in capital structure: The capital structure of the company can be kept flexible by this method of finance. Fixed
deposits can be returned if the company is overcapitalized. On the other hand, additional finance can be raised without much
difficulty, in case of need.
5. Economical : It is economical because the rate of interest allowed on deposits is usually less than the interest rate charged
by banks and other financial intuitions on loans.
6. Trading on equity: Interest on Deposts is paid at a fixed rate. In case the earnings of the company good, the rate of
dividend on equity shares can be increased.
DISADVANTAGES:-
1. Unsuitable for new concerns: This method is not suitable for new companies as the public may be hesitant to invest for
fear of loss of money.
2. Uncertainty of getting deposits: Public deposits are called “fair weather friends”. There is no certainty of getting a good
response from public particularly in period of depression.
3. Unsecured: Depositors face high risk as public deposits are secured on the assets of the company.
4. Restrict growth of capital market: Public deposit hamper the grown the healthy capital market in the country.
Widespread use such a source may create shortage of industrial security. It may also pose a threat to the credit planning and
plan priorities of the Govt.
5. Possibility of cheating( speculations): It is possible that a company may project a good picture to attract public deposits.
The funds procured may be misused and thereby innocent investors may be cheated.
 6. Loss of creditworthiness: If the deposit money is not paid on maturity on account of shortage of liquid resources,
the goodwill of the company may be adversely affected.

2. Commercial Banks:
Lending is an important function of commercial banks. Banks provide finance to business enterprises in the following ways:
1. Loans and Advances: the key features are as follows:

 It is lump sum money advanced by way loan to the borrower for which a bank opens a separate account in the name of
the borrower in which the amount is credited.

 Interest : the borrower is required to pay interest on the whole amount from the date the loan was sanctioned.

 Repayment: The loan may be repaid either in instalments at regular interval or in one time at the expiry of a fixed
term of loan.

 Withdrawal: the borrower can withdraw the whole of the amount or a part of it but interest is charged on the whole
amount of loan.

 Security: The loan may be secured or unsecured. However in most cases the banks ask for sufficient security from the
borrower before sanctioning the loan.

2. Cash Credit: Its key features are as follows:

 Cash credit is a kind of agreement with the bank under which a bank fixes a maximum limit up to which the borrower
can withdraw money. It is a running account from which the amount can be withdrawn and paid back as per the needs of the
customer.

 The limit is usually fixed based on the reputation and security offered by the borrower.

 Interest is charged only on the actual amount withdrawn.

The main advantage is flexibility in the use of money and the convenience. The customer does not have to approach the bank
again and again in case of need of funds.
The disadvantage is the high rate of interest.
3. Bank Overdraft: Main points are:

 Overdraft is facility of withdrawing/making payment more than the balance in the bank.

 Overdraft facility is granted to customers having a current account with the bank.

 A maximum limit of overdraft is fixed based on the reputation ( credit worthiness) of the customer and the security
offered by him.

 Interest is charged on the actual amount of overdraft.

This is a very convenient and flexible one time form of short term financial arrangement with the bank and the customer
does not have to ask bank if the payment exceeds the balance in the bank.
4. Discounting of Bills: Main points are:

 Discounting of bills means getting cash from a bank in exchange of Bills of exchange ,promissory note etc.

 Bank charge some commission/interest for this service by paying amount lower than the face value of the bill. The charges are
for the unexpired time period of the bill. These are called discounting charges.

 On maturity date of the bills, the bank will collect full amount of the bill from the drawee ( debtor).

 The borrower/customer remains liable to the bank, if the drawee fails to honour the bill on its due date.

Advantages of funds from Commercial Banks:

Bank Credit has several advantages:
1. Flexible: Bank credit is highly flexible. There are many options for raising short term funds. The money can be repaid
whenever desired.

2. No interference in management: Commercial banks do not interfere in the working of the company. Only financial
statements are to be submitted at the specified time.
 3. Easy repayment option : In all the lending options, the banks provides easy repayment option to the borrower, which
is not available in any other forms of borrowing.

4. Economical: short term funds from banks prove to cheaper. This reduces interest burden on the borrower.

Disdvantages:
1. Legal formalities:

2. Shorter period of funds: Funds from commercial banks are mostly for shorter periods.

3. Charge on assets: Banks generally require a charge on the assets of company before funds are sanctioned.

4. High rate of interest: The rate of interest charged by the banks is higher than interest on debentures or public
deposits.

Trade Credit :
 Trade credit is a credit extended on purchase of raw material or finished goods on credit. The payment for
purchased is to be made later on. Trade credit does not include purchase of assets on credit.

 The credit period range from 15 days to three months.

 Trade credit is unsecured and the credit is allowed by sellers to buyer based on the financial reputation of the buyer
or trade practice in the industry, financial strength of the buyer, nature of products etc.

Advantages
1. Simple : Trade credit is convenient source of short term credit and does not involve much formalities.

2. No interest: No interest is payable for the period of credit.

3. No security : The buyer is not required to give any security or pledge assets.

4. Flexible : The payment system is quite flexible and depends upon mutual agreement between the seller and the
buyer.

Disdvantages

1. Higher prices: The prices of goods sold is generally higher when trade credit is allowed.

2. Available for short term : the maximum period of credit is only 3 months.

3. Possibility of Bad Debts: The seller may have to bear the bad debts if the buyer is unable to pay the amount.

4. Large working capital: the sellers need to keep large amount of working capital when he sells the goods on credit and
allows longer credit period.

Instalment Credit:
 It refers to purchase of durable items like plant and machinery, furniture etc. on credit.

 The buyer has to pay part of the price at the time of taking delivery of goods, known as down payment. The balance of
the amount is to be paid in instalments.

 The seller/supplier charges interest on the balance due and interest is included in the instalment. In some cases, the
credit is allowed through finance company or commercial banks.

 The physical possession of the asset is given to the buyer immediately on signing of agreement and down payment but
the ownership of the asset is transferred only on payment of final instalment.

Factoring : (Accounts Receivable Financing)

 Accounts Receivable finance is defined as raising of funds through mortgage or sale of Trade Receivables.
 In case of mortgage of receivables, finance companies (factors) provide loans on the security of these receivable,
generally upto 60% of amount of such security. The debtors of the firm may directly make payment to the finance company or to
the firm, which in turn will use that money to return the loan amount. Bad debt, if any will be borne by the firm and not the
finance company. The rate of interest on such loans is quite high.
 In case of outright sale of receivable, the finance company purchase debtors and receivable at a heavy discount. The
finance company, in turn will take the entire responsibility of collecting the money and will be bad debts, if any.
Customer Advance:
  It refers to that part of the price which is taken in advance from customers at the time of booking or before
the delivery of goods.

 A nominal interest may be paid on such advance.

 When delivery of goods is given to the buyer, the advance money is adjusted against the price of the article.

 Advance can only be taken from customers when the advance booking of the product is done or the product is in high
demand.

 The advance received provide working capital to the firm.

Inter-Corporate Deposits:
 It refers to deposits by one company with another company. In other words, Inter corporate deposit is the process of
borrowing of money by one company from another company. A company having surplus money may lend to other companies
which may need financial assistance.

 Period of Deposit: Maximum six months

 It is a popular source of short-term finance.
 Procurement procedure is simple.
 The rate of interest on such deposits is not fixed. It depends upon the
amount involved and the tenure of lending.
 It is uncertain source of finance, as deposit can be withdrawn any time—so it
is risky also.

Types:
Inter corporate deposits are of three types:
1. Call Deposit:
Such a type of deposit is withdrawn by the lender by giving a notice of one day. However, in practice, a lender has to wait for at least 3 days.
2. Three-month Deposit:
As the name suggests, such type of a deposit provides funds for three months to meet up short-term cash inadequacy.
3. Six-month Deposit:
The lending company provides funds to another company for a period of six months.

The advantages of inter-corporate deposits are:

i. No procedural Problems: These deposits do not involve any procedural
problems
ii. Meeting Short Term Requirements: Inter-Corporate deposits are a good
source of meeting short term funds requirements.
iii. Easy Availability: These are easily available from companies, which have
surplus funds.
Disadvantages:
i. Short Term: Such deposits are available only for short period.
ii. Higher Interest rates: The rate of interest charged on such borrowings is
quite
iii. These deposits can usually be availed by reputed companies.