Chapter-8

CHAPTER – 8

SOURCES OF BUSINESS FINANCE

Every business, irrespective of its nature, type or size needs finance for its operation.
Availability of adequate fund is essential for the smooth functioning of the business. Finance
is the life blood of every business. It is important for every entrepreneur who wants to start a
business to know about different sources from which money can be raised. It is also
important to know the relative merits and demerits of different sources, so that choice of an
appropriate source can be made.

Business Finance

Business finance is concerned with acquisition and utilization of capital to carry out
various business activities of an organization. The initial capital contributed by the
entrepreneur is not always sufficient to meet all financial needs of the business. A business
man, therefore, has to look for different sources from where the need for funds can be met.
Thus business finance refers to money and credit employed in a business firm in order to
carry out its operation smoothly. Business finance may be defined as planning, raising,
managing and controlling all types of funds needed for a business.

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Nature of Business finance

Finance is required to commence and carry on business. No growth and expansion of
business can take place without sufficient finance. The larger, the size of the business, the
larger will be the finance required. No business activity is possible without finance. Business
finance has the following special features:

a) Essential in a business
Business activities are not possible without finance.

b) Needed everywhere
All business enterprises, whether large or small need finance.

c) It includes all types of funds

It includes both owned capital and borrowed capital.

d) It is a wider term
Business finance is a wider term. It is concerned with planning, acquiring, utilizing
and managing funds.

Significance of business finance

Finance plays a vital role in the functioning of modern enterprises. It is said to be the
lifeblood of business. Finance needed in at every stage in the life of a business. It must be
available at the proper time. It must be adequate for the purpose for which it is needed.
Insufficient fund may affect the growth of the firm adversely. Finance is required to start a
business, to operate it, as well as for modernization and expansion. While starting a business,
money is needed to purchase fixed assets and also to meet day-to-day expenses.
Classification of Sources of Funds

The various sources of funds can be classified on the on the basis of viz. (1) Period (2)
Ownership and (3) Source of Generation.

I. Classification on the basis of period

On the basis of period of time for which finance is required, business finance can be
classified into three. They are:

1. Long term finance

2. Medium term finance
3. Short term finance.

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1. Long term finance

Long term finance refers to the funds which are to be invested in the business for a long
period, say for a period over 5 years. Such finance is used for investment in fixed assets like
land, building, plant, machinery, furniture etc.This is known as fixed capital requirements of
an organization. Long term finance is acquired through issue of shares, debentures or loan
from specialized financial institutions.

The volume of long term fund required by a business depends up on the nature and
size of the business unit. Manufacturing concerns requires more long term finance than
trading concerns. Long term finance is required for financing capital expenditure. They are
also known as fixed capital or block capital.

2. Medium term finance

Where the funds are required for a period of more than one year but less than five
years, it is known as medium term finance. The need for medium term finance may be for
increasing the production capacity, introduction of a new product, modernization of plant and
machinery, making an advertisement campaign etc. Medium term finance can be raised
through public deposits, lease financing, loan from financial institutions and commercial
banks.

3. Short term finance (working capital)

Short term finance is raised for a period of less than one year. It is required to meet the
day to day needs of the business. It is known as working capital of an organization. It is the
amount required for investment in current assets like stock of row materials, debtors, bills
receivable also funds required for current expenses such as, wages, salaries, rent etc. The
current assets can be converted in to cash within a short period. Trading concerns require
more short term finance than manufacturing concerns. Amount of working capital determines
the length of operating cycle. Lesser short term finance will be required, if the gap between
production and sales is lesser and vice versa. Main sources of short term finance are trade
credit, bank loan, customer advance etc.Short term finance is also known as revolving capital
or circulating capital.

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Operating cycle

Operating cycle refers to the time required for production process and realizing cash

after the sale of such goods. If the operating cycle is short, only small amount of short term

finance is required and vice versa.

Fig: operating cycle

II. Classification on the basis of ownership

The business can raise its required finance from two main sources. They are (1)
Owners funds (2) Borrowed funds.

1. Owners Fund

Owned capital refers to the amounts contributed by the owners into the business. In a sole
proprietorship, the proprietor brings the owned funds from his personal property. In a
partnership, the capital contributed by the partners is called owned funs. Funds raised by the
issue of shares and retained earnings are the owned funds in a joint stock company. It will
remain in the business over a long period and is not expected to be withdrawn otherwise than
on the winding up of the business.

2. Borrowed funds
Borrowed funds refer to fund raised from external borrowings. The sources of
borrowed funds include issue of debentures, public deposits, trade credit and loans from

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financial institutions and banks. Periodical payments of interest and repayment of loan
amount on expiry date are required even if there is no profit. Moreover, borrowed funds are
available only on mortgage of fixed assets.

III. Classification on the basis of source of generation

It includes internal and external sources of funds:

1. Internal sources of funds

The sources of funds which are generated by the business itself are known as internal
sources of funds. Collection of receivables, retained earnings, disposing of surplus
inventories etc.are the main internal sources of business finance. Only limited needs of
finance are fulfilled by these sources.

2. External sources of funds

External sources of funds are those that are generated from outside the business. For
example, loans from commercial banks and financial institutions, issue of debentures, public
deposits, lease financing, trade credit, factoring etc. Requirement of large amount of funds
can be fulfilled by these sources. The funds raised through these sources are costly as
compared to the funds raised through internal sources. Sometimes the business firm has to
even mortgage their assets as security while raising funds from these sources.

Different sources of finance.

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Sources of Finance
A source of finance means the agency from which finance is procured for the
business. A business can raise funds from various sources. In case of sole trading concern
and partnership concern, the main sources of capital are the proprietors themselves. But in
joint stock companies due to the nature of large scale operations, require huge capital. Each
source has its own advantages and disadvantages. There is not a single best source of funds
for all organizations. A brief description about various sources, along with their advantages
and limitations are given below:

I. Retained profit
II. Trade Credit
III. Factoring
IV. Lease Financing
V. Public deposits
VI. Commercial Paper (CP)
VII. Issue of Shares
VIII. Issue of Debentures
IX. Loan from Commercial banks
X. Loan from Financial Institutions
XI. International Finance

I. RETAINED PROFIT (Ploughing back of profit)

Out of total profits earned by a company in a particular year, a certain percentage is
retained in the business without distributing as dividend among share holders, this
undistributed profit is known as retained profit. It is a source of internal financing or self
financing. It is also known as ‘ploughing back of profit’. It is treated as an ownership fund
and will serve the purpose of long term and medium term financing.

It is a usual practice of a company to transfer a part of its profit to general reserve

every year. When these reserves are accumulated into a large amount, after a few years, this
can be employed in modernization, expansion etc. of the business.

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Advantages of retained earnings

This type of finance has the following advantages:-

1. It is the most convenient source of finance. It requires no advertisement, no issue of

prospectus or no legal formalities.
2. Retained profits create no charge on the assets of the company. Further loans can be
raised on the security of assets.
3. There is risk of losing control to the management when a fresh issue of shares is
made. But management retains its control when it uses retained profits.
4. Retained profits increases the financial strength and earning capacity of the business.
The company enjoys more borrowing capacity also.
5. As an internal source, it is more dependable than external source.
6. There is no fixed obligation to pay dividend on the profits reinvested
7. Retained earnings is a permanent source of funds available to an organization.
8. It may lead to increase in the market price of the equity shares of a company.

Disadvantages of retained earnings

Retained earnings as a source of funds has the following limitations:

1. In some cases, it may lead to over capitalization. Over capitalization means presence
of idle capital and reduced rate of earnings.
2. Excessive ploughing back may cause dissatisfaction amongst the shareholders as they
would get lower dividends.
3. It is an uncertain source of funds as the profits of business are fluctuating.
4. The company runs the risk of being converted into a monopolistic organization.
5. Growth of companies through internal financial may attract the government
restrictions as it leads to concentration of economic power.

II. Trade credit

Trade credit is the credit extended by one trader to another for the purchase of goods and
services. Trade credit facilitates the purchase of goods without immediate payment. Such

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credit appears in the book of the buyer as sundry creditors. It is commonly used by the
business organization as a short term source of financing. The volume and period of trade
credit depends on factors such as reputation of the purchasing firm, financial position of the
seller, volume of purchase, competition in the market etc.

Advantages of trade credit

1) Trade credit is a convenient and continuous source of funds.
2) Trade credit needs to promote the sales of an organization. It is important technique to
increase sales.
3) It does not create any charge on the asset of the company.
4) It is a readily available source of finance.
5) Trade credit facilitates purchase of goods and services without immediate payment.

Demerits of trade credit

1) Trade credit may result in over trading which increases the risks of the business.
2) Only limited amount of funds can be generated through trade credit.
3) Trade credit is a costly source of funds as compared to other sources.

III. Factoring
If refers to the practice of raising funds by selling a firm’s account receivable to another
company or agency. Credit management is a specialized activity as it requires skill and
involves a lot of time and effort. Therefore debt collection is a serious problem for firms.
Banks usually grant working capital finance on receivables for a short period only (3 to 6
months). Hence debt collection activity may be entrusted with specialized agencies called
factoring organizations. This agency or individual which specializes in collection and
administration of debt is called a factor. Following are some of the services provided by
factoring agencies:

a. Discounting bills of exchange.

b. Factors collect client’s debts and provide full credit protection against bad debts.
c. Factors also provide information about credit worthiness of prospective clients.

Factors do these services in return for a factoring commission and interest on advance
granted. First factoring company in India is SBI Factors and Commercial Services
Limited.

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Advantages of factoring
1) The client can concentrate on other functional areas of business as the responsibility
of credit control is shouldered by the factor.
2) Factoring ensures timely payment of account receivable. It helps the client to meet his
liabilities as and when they arise.
3) It provides protection to the firms against bad debt losses.

Limitations of Factoring
1) This source is considered to be very expensive when the the number of invoices are
large in number and amount is very small.
2) The customer may not feel comfortable in dealing with the third party i.e,the factor.
3) They advance finance at a higher rate of interest as compared to the usual rate of
interest.

IV. Lease Financing

A lease is 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. Leasing is an
arrangement of acquiring the right to use an equipment or asset without actually owing the
same. The owner of the assets is called the lessor and the user is the lessee. The lessee has to
pay a specified amount called lease rent to the lessor for the use of the asset. Payment is
made as regular fixed payments over a period of time at the beginning or at the end of a
month, quarter or year.

Normally there is an agreement between the lessor and lessee. This agreement
includes provisions about period, cancellation, lease rent, purchase option, maintains etc. At
the end of the period, the assets revert to the lessor who is the legal owner of the asset.
Lessors may be a leasing company or manufactures of equipments. This type of finance is
very helpful in acquisition of such assets like computers,electronic equipment etc.as become
obsolete very soon.

Advantages of lease financing

1. It is an easiest source of long term finance for fixed assets.

2. The lessee is freed from the risk of the assets becoming obsolete as he could cancel an
old lease agreement.

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3. It enables the lessee firms to make full use of the assets without making immediate
payment of huge purchase price. Lease rent may be matched with the cash flow of the
lessee.
4. Tax advantage. The full amount of lease rent is an admissible deduction under income
tax Act.
5. Asset is made available to the lessee for immediate use without loss of time in
applying for a loan and complying with formalities in acquiring the asset.
6. It provides finance without diluting the ownership or control of business.

Disadvantages of lease financing

1) Lesser may impose certain restrictions on the use of assets.
2) The normal business operations may be affected in case the lease is not renewed.
3) It may result in higher payout obligation in case the equipment is not found useful and
the lessee opts for premature termination of the lease agreement.

V. PUBLIC DEPOSITS
The deposits that are raised by organistions directly from the public as loan or debt are
called public deposits. Companies advertise in newspapers for inviting general public to
invest their savings in public deposits. Rate of interest offered on public deposits are
usually higher than that offered on bank deposits. Companies generally invite public
deposits for a period up to three years. It is a source of medium term or short term
finance. Public deposits are unsecured loans and the depositors are like ordinary creditors.

Advantages of public deposits

1. The company need not provide any security against the public deposits,so public
deposits will not create any charge on the assets.
2. Public deposits are flexible source of short term finance. They can be accepted even
for a short period of six months
3. Public deposits are a convenient source of finance since not much legal
formalities are involved
4. As the depositors do not have voting rights, the control of the company is not diluted.

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5. Financing through public deposits is a method of trading on equity. Interest on public

deposits is paid at a fixed rate. This facilitates a company to declare more dividends to
its equity share holders in years of high earnings.

Disadvantages of public deposits

1) Only large companies enjoying public confidence can raise capital through public
deposits
2) They are not secured. The depositors are considered as ordinary creditors.
3) They are costly as most of the companies have to offer high interest to attract public
deposits.
4) The RBI has laid down certain limits on public deposits.
5) Investors are entitled to withdraw their deposits at any time after giving prior notice to
the company.

VI. Commercial paper (cp)

It is an important source of short term finance having a maturity period of 7 days to
one year. Commercial paper is an unsecured promissory note issued by a firm to other
business firm, insurance companies, banks etc. Being an unsecured debt, CP can be issued
only by the firm having good credit rating. Commercial paper is usually issued at a discount
from face value and reflects prevailing market interest rates. It can be traded like other
negotiable instrument.RBI regulates commercial paper.

Merits
1) It is the best suitable instrument to raise shot term finance.
2) As it is a freely transferable instrument, it has high liquidity.
3) Companies can park their funds in commercial paper thereby earning some good
return on the same.
4) It is a continuous source of funds.

Demerits
1) Only financially sound and highly rated firms can raise money through commercial
papers. Therefore, new and moderately rated firms can’t raise funds by this method.
2) The size of money raised through CP depends upon the liquidity position of money
suppliers. It is not a sure source of finance.
3) Issue of commercial paper is strictly regulated by RBI.

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VII. Issue of shares

The capital raised by issue of shares is known as share capital. The capital of a
company is divided into small units called shares. Share holders are the owners of the
company. Each share has its nominal (Face) value. For example a company can issue
5,00,000 shares of Rs. 10 each for a total value of Rs. 50,00,000.The person holding the
share is called the share holder. There are two types of shares issued by a company. They are:
(1)Equity shares and (2) preference shares.

A. Equity shares

Equity shares were earlier known as ordinary shares. The holders of these shares are the
real owners of the company. They have a voting right in the meetings of shareholders of the
company. They have a control over the working of the company. Equity shareholders are
paid dividend after paying it to the preference shareholders. The amount of share capital
which is raised by issue of equity share is known as equity share capital.

The rate of dividend on these shares depends upon the profits of the company. They may be
paid a higher rate of dividend or they may not get anything. These shareholders take more
risk as compared to preference shareholders.

Equity capital is paid after meeting all other claims including that of preference shareholders.
They take risk both regarding dividend and return of capital. Equity share capital normally
cannot be redeemed during the life time of the company.

Capital Structure - Reliance Industries Ltd.

Authorized
Period Instrument Capital Issued Capital -PAIDUP-

Shares
From To (Rs. cr) (Rs. cr) (nos) Face Value Capital (Rs. Cr)

2017 2018 Equity Share 14000.0 6334.7 6334651022 10.0 6334.7

2016 2017 Equity Share 5000.0 3251.3 3251278100 10.0 3251.3

Features of equity shares

1) Risk bearers: Equity share holders are entitled to receive what is left after all prior
claims have been paid. They provide funds to the company not on the basis of any
security.

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2) No fixed rate of dividend: The rate of dividend on equity capital depends upon the
availability of surplus funds. There is no fixed rate of dividend on equity capital. It is
paid out of the residual profits after paying interest on debentures and dividend on
preference shares.
3) Right to vote: Equity shareholders have voting rights and elect the management of
the company.
4) Permanent source of finance: Equity share capital remains permanently with the
company. It is returned only when the company is wound up.

Merits (Advantages) of Equity shares

Equity shares have the following merits.

1) Source of fixed capital

It is the best source of long term finance. A company has no obligation to repay its
equity share capital except at the time of winding up of the company subject to
availability of funds.

2) No obligation to pay dividend

Payment of dividend to the equity shareholders is not compulsory. Therefore, there is

no burden on the company in this respect.

3) No charge on assets

Funds can be raised through equity share issue without creating any charge on the
asset of the company .So companies assets can be used for raising additional loan.

4) Voting right

Equity share holders enjoy full voting right in the management of the company.

5) High return

If the company is successful and the level of profit is high, equity share holders enjoy
very high return.

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6) It create confidence among creditors

Equity capital provides credit worthiness to the company and confidence to
prospective loan providers. Equity share capital act as a cushion to creditors.
7) Real Owners

Equity shareholders are the real owners of the company who have the voting rights in
all matters.

Demerits (Disadvantages) of Equity shares

The major limitations of raising funds through issue of equity shares are as follows:

1. Not suitable to cautious investors

Investors who desire to invest in safe securities with a fixed income have no attraction
for equity shares.

2. Dilutes the control

An additional issue of equity shares dilutes the control of existing share holders.

3. Not flexible

Equity share capital is a permanent source of finance. It can’t be refunded during the
life time of the company.

4. Danger of manipulation

The management of the company may declare dividend at higher or lower rates. It will
cause fluctuation in the value of shares .There is always danger of manipulation of
share price.

Danger of over capitalization

Issue of equity shares in excess of its financial requirements of a company will

make overcapitalized. This results in low earning capacity by the presence of
idle capital.

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1. Government restrictions

Raising equity share capital beyond a certain limit is subject to government

restrictions.

2. Complicated procedures
More formalities and procedural delays are involved while raising funds through
issue of equity share.

B.Preference shares
Preference shares are those shares which have preferential right over equity share in
case of payment of dividend and repayment of capital at the time of winding up. They
are entitled to a fixed rate of dividend before any dividend is paid to equity share
holders. Preference shares are better suited to the needs of cautious and conservative
investors who wants certainly of income and security of their investment. However
the rate of dividend specified in preference shares is not guaranteed. If any year’s
profit is not sufficient to declare dividend on shares the preference share holders will
not get dividend. There is also a restriction on their voting rights. They have right to
vote only on matters affecting their interest like nonpayment of dividend.
Features of preferences shares
1. Preference
If there is profit and dividend is declared, dividend at a fixed rate must be paid first to
the preference shareholders. The balance, if any, can be districted among equity share
holders. They also have the preference in case of repayment of capital.

2. Restricted voting right

Preferences shares carry limited rights over the management of the company.

3. Fixed percentage of dividend

Preferences shareholders get only fixed percentage of dividend even if the company
makes good profits.

Kinds of preferences shares

Based on the terms and conditions, different types of preference shares may be issued
by a company to raise funds.

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1. Cumulative and Non cumulative preferences shares

In case of cumulative preference shares, if dividend is not paid due to inadequate profit in a
particular year, the amount of dividend will accumulate and will have to be paid out of
profits of future years. Preference shares are always cumulative unless otherwise stated.

A non cumulative preference shares is one in respect of which dividend do not accumulate, if
they are unpaid. Arrears are not carried forward to subsequent years.

2. Participating and Non participating preference shares

A participating preference shares carries a right to share in surplus profits left after a fixed
dividend is paid both preference and equity shares. The holders of these shares get a part of
residual profit in addition to the fixed rate of dividend.
Non participating preferences shares carry a right of only a fixed rate of dividend. The
holders have no right to share in the residual profit of the company.

3. Redeemable and Irredeemable preferences shares

Redeemable preference shares are those preference shares in which the company can repay
the mount of such preference shares after a specified period.

Irredeemable preference shares are those shares which are redeemable only at the time of
winding up of the company. They can’t be paid up during the life time of the company.

4. Convertible and Non convertible preferences shares

Preferences shares which can be converted into equity shares after a fixed period is known as
convertible preference shares.

The preference shares which do not carry a right of conversion into equity shares are
called non convertible preference shares.

Advantages of preference shares

1. Suitable to cautious investors

It is suitable for cautious investors who look for a regular return and reasonable
safety.

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2. No obligation for dividend

Dividend is payable only when there is sufficient profit.

3. No interference in management

They have only restricted voting right. Preference share issue will not dilute the
control of equity share holders.

4. No charge on asset

Preferences shares do not create any charge on the asset of the company.

5. Preferential right

Preference shareholders have a preferential right on repayment of capital over

equity shareholders in the event of liquidation of a company.

6. Flexibility

They can be redeemed, if necessary. Issue of redeemable preferences shares

help a company to replay the capital when it is no longer required in the business.

DISADVANTAGES OF PREFERENCE SHARES

The major limitations of preference shares as a source of business finance are:

1) Limited voting right

Preference shareholders are ordinarily denied the right to vote except under specific
conditions.

2) Low return

Preference shares are not suitable for those investors who are willing to take
risk and are interested in higher returns.

3) Costly source of finance

The rate of dividend on preference shares is generally higher than the rate of
interest on debentures.

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4) No tax benefit
The dividend paid is not deductable from profits as an expense. Thus, there is no tax
savings as in case of interest on loan or debentures.

III. ISSUE OF DEBENTURES

Debenture is an important instrument for raising long term debt capital. A company
can raise funds through issue of debentures, which bear a fixed rate of interest. A debenture
is a certificate or document issued by a company under its seal as an acknowledgement of its
debt. It is also an undertaking by the company to repay specified borrowed sum to the
debenture holder. Debenture holders are creditors of the company. Debenture holders are
paid a fixed stated amount of interest at specified intervals.

Public issue of debentures requires that the issue be rated by a credit rating agency
like CRISIL (Credit Rating and Information services of India Ltd).The credit rating agency
rate the issue on aspects like track record of the company, its profitability, debt servicing
capacity, credit worthiness etc.

examples of credit rating:

If the rating of debenture is AAA (Triple A), then it is considered to have the
highest safety for the investor.

If the credit rating is DDD (Triple D),, then the debenture is considered to have
highest risk for the investor.)

Features of Debenture

1. A debenture is a certificate is an acknowledgement of debt of a company.

2. Debenture represents borrowed capital.
3. Interest on debenture is payable at a fixed rate.
4. Debenture holders are creditors of the company
5. Debenture holders have no voting rights.

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6. Interest on debenture is a charge against profit.

7. It can write as an expense on the debit side of the profit and loss account.
8. Debenture may involve a charge on the assets of the company.

Types of debentures

1. Naked or simple debentures

These debentures are unsecured and do not carry any charge on the assets of the company.
The holders of unsecured debentures are considered as ordinary creditors in the event of
winding up of the company.

2. Secured or Mortgage Debentures

These debentures carry a charge on the assets of the company. Secured debentures have a
claim on the assets of the company. The charge may be fixed or floating. If specified assets
like machinery, building etc. are charged as security it is a fixed charge.

3. Redeemable debentures

Debentures issued with a condition that they will be redeemed or repaid after a specified
period are called redeemable debentures. It provide flexibility to the capital structure.

4. Irredeemable debentures

These debentures are repayable only at the time of winding up of the company. They are also
known as perpetual debentures.

5. Convertible debentures

The holders of these debentures have an option to convert their holding s in to equity shares
after a specified period

6. Non- Convertible debentures

These debentures cannot be converted in to shares in future. The holders of such debenture
remain creditors of the company.

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7. Registered Debenture

In case of registered debentures, the name, address and other details of debenture holders are
entered in the books of the company. They cannot be transferred by mere delivery, it require
a transfer deed.

8. Unregistered or Bearer Debentures

The company keeps no record of the holders of these debentures. The company made
payment to the holders of these debentures. They are transferable by more delivery.

Advantages of debentures

The merits of raising funds through debentures are given as follows:

1. It is suitable to investors who want fixed income at lesser risk. They guarantee a fixed
rate of interest.
2. Interest paid is a deductible expense. So tax savings is possible.
3. As debentures do not carry voting rights, financing through debentures does not
dilutes control of equity shareholders on management.
4. Debentures enable the company to the advantage of trading on equity.
5. It provides flexibility to the capital structure as debentures can be redeemed at any
time when company has surplus funds
Disadvantages of debentures
A debenture as source of funds has certain limitations. They are given as follows:
1. Interest on debenture is an obligation to the company. It is to be paid annually
irrespective of the profit of the company.
2. Debenture holders do not enjoy any voting rights in the company.
3. Debenture issue is not suitable for companies with unstable future earnings.
4. Debenture issue may not be possible beyond a certain limit due to inadequacy of
assets to be offered as security.

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DIFFERENCE BETWEEN SHARES AND DEBENTURES

Basis of
Shares Debentures
Difference

1. Ownership A share is an ownership security A debenture is a creditor ship

security

2. Position A share holder is an owner of the A debenture holder is a creditor

company of the company

3. Return on Shareholders get dividend as the Debenture holders get interest

investment return as the return

4.Guarantee of Rate of return is fluctuating, depending Rate of interest is fixed

return upon the earnings of the company irrespective of profit or loss of
the business

5. Voting right Share holders have voting rights Debenture holders have no
voting rights

6. Redeemability Shares can’t be redeemed (except Redeemable debentures can be

redeemable preference shares) during redeemed during the life time
the life of the company of the company

7. Security No charge is created on the assets of the The debentures are generally
company secured by creating a charge on
the assets of the company

8. Priority for At the time of winding up of the Debentures are repayable in

repayment of company, share capital is payable after priority over share capital
investment meeting all outside liabilities

IV. LOANS FROM FINANCIAL INSTITUTIONS

The government has established a number of financial institutions all over India to
provide finance to business organizations. They provide both owned capital and loan capital

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for long and medium term financial requirements. As these institutions aim in promoting the
industrial development of a country, these are also called development banks. Examples for
development banks are-Industrial Finance Corporation of India (IFCI), State Finance
Corporation of India (SFC), Industrial Credit and Investment Corporation of India(ICICI),
Industrial Development Bank of India(IDBI) etc.

Development banks differ from commercial banks in many respects. Commercial

banks grant credit for short term requirements. But development banks provide finance on
medium and long term basis. Another major difference is that commercial banks are highly
security oriented in their dealings. But development banks are project oriented.

Functions of development banks

1. Long term and medium term financial assistance to industries at a reasonable rate of
interest.
2. Subscribe shares and debentures issued by companies.
3. Underwrite the issue of shares and debentures of companies.
4. Give guarantee for loans obtained by such companies from other financial institutions
and banks.
5. Give loans in foreign currency for industries to import machinery.

Merits of raising loan from financial institutions

I. They provide long term finance, which are not provided by commercial banks.
II. Besides providing funds, many of these institutions provide financial, technical and
managerial advice to business firms.
III. They provide funds even during the periods of depression, when other sources of
finance are not available.
IV. Obtaining loans from financial institutions increases the goodwill of the borrowing
company in the capital market.

V. Loan from banks

Commercial banks occupy an important position as they provide funds for different purpose
as well as for different time period. Banks extend loan to firms in many ways like cash credit
(CC), over draft (OD), term loans, discounting bills of exchange etc.The borrower is required
to some security or create charge on the assets of the firm before a loan is sanctioned by a
commercial banks.

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INTERNATIONAL SOURCES OF FINANCE

In addition to the above domestic sources of funds, there are various avenues to raise funds
internationally. Various international sources from where funds may be generated include:

1. International agencies and development banks

A number of international agencies and development banks have emerged over the years to
finance international trade and business. These bodies provide long and medium term finance
to trade and industries. Examples for international bodies are International Finance
Corporation (IFC) Asian Development Bank etc.

II. International capital market

Through the process of liberalization, Indian companies are now free to access global
capital markets for raising finance. Thus, international finance has become accessible to
Indian corporate enterprises. The main instruments through which companies in India can
raise finance from the international capital market are Global Depository Receipts (GDRs)
and American Depository Receipts (ADRs).

A. Global Depository Receipts (GDR)

Global Depository Receipts are created by overseas depository Bank and issued to
non-resident investors against the issue of ordinary shares of issuing company. They are
dollar denominated instruments.

After getting approval from the Ministry of Finance and completing other formalities
the issuing company issue shares to the overseas depository Bank and overseas depository
then issues dollar denominated Global Depositing Receipts (GDR) against the shares
registered with it. The non-resident investors purchase GDR and not shares of Indian
Company. The Depository receives dividend, notice and reports of the company and in turn
issues GDR as claims against shares held. These claims are called GDR and traded as
receipts in the global market.

Features
1. It is traded in Europe
2. The holders of GDR have no voting right.
3. GDR help in tapping international capital for Indian companies.
4. It is a dollar denominated negotiable instrument.

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B. American Depository Receipt (ADR)

ADRs are negotiable receipts issued to nonresident, investors by an authorized

depository, normally a US Bank, in lieu of shares of the issuing (Indian) Company, which is
actually held by the Depository.

ADRs can be listed and traded in US based stock exchange and help the Indian
company to be known in the highly liquid US stock exchanges. ADR also help in the US
based and other foreign investors to have the twin benefits of having share holding in a high
grown Indian company and the convenience of trading in a highly liquid and well known
stock exchange. The depository receives dividend directly from Indian company in rupees
and issue dividend cheques to ADR holders in dollars.

Difference between GDR and ADR

1. ADRs are listed in American Stock Exchange. But GDRs are traded in European
Stock Exchange.
2. Both individual and Institutional investors can make investment in ADR. But only
institutional investors can invest in GDR.
3. ADR can be converted into shares and shares to ADR. But in case GDR once
4. Converted into shares, if can't be converted back.
5. Legal and accounting cost is high in case of ADR as compared to GDR.
III. Foreign Direct Investment (FDI)

FDI refers to direct subscription to the equity capital of an Indian company by a

multinational corporation. Until 1991, FDI was permitted up to 40% of the equity capital of
the company. This ceiling was since removed and the government is encouraging 100%
FDI.

Factors affecting the choice of the source of funds

The factors that affect (Influence) the choice of source of finance are:

1. Cost:
The cost of procurement of funds and cost of utilizing the funds should be taken into account
while deciding about the source of funds that will be used by an organization.

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2. Purpose and Time period:

Business should plan for fund according to the time period for which the funds are required.
A short period need can be met through borrowing funds at low rate of interest through trade
credit, commercial paper etc.For long term finance, sources such as issue of shares and
debentures are more appropriate.

3. Control:

Business firm should choose a source of finance keeping in mind the extent to which they are
willing to share their control over business.

4. Flexibility:

Flexibility means that, if need be, amount of capital in the business could be increased or
decreased easily. Reducing the amount of capital in business is possible only in case of debt
capital or preference share capital.

5. Company's Tax Exposure

Debt payments are tax deductible. As such, if a company's tax rate is high, using debt as a
means of financing a project is attractive because the tax deductibility of the debt payments
protects some income from taxes.
6. Risk:

Business should evaluate each of the sources of finance in terms of the risk involved.

7. Form of organization:

The form of business organization influences the choice of a source for raising money. A sole
trading concern or a partnership can’t issue shares to the public.

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Prepared by, BINOY GEORGE, HSST, MKNM HSS, Kumaramangalam, Thodupuzha

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