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ASSIGNMENT

TOPIC: Sources of Finance (Long-

term, Medium-term & Short-term)

Submitted To:
Submitted By:
Jeenu Mathew
Athul R
Associative professor
S2 MBA Batch B
(Management Studies)
Roll no :16
Mangalam College of
Engineering Mangalam college of
Engineering
Submitted On:31-05-2021
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Introduction
Sources of capital are the most explorable area especially for
the entrepreneurs who are about to start a new business. It is
perhaps the toughest part of all the efforts. There are various
capital sources, we can classify on the basis of different
parameters. Having known that there are many alternatives to
finance or capital, a company can choose from. Choosing the
right source and the right mix of finance is a key challenge for
every finance manager. The process of selecting the right
source of finance involves in-depth analysis of each and every
source of fund. For analysing and comparing the sources, it
needs the understanding of all the characteristics of the
financing sources. There are many characteristics on the basis
of which sources of finance are classified. On the basis of a time
period, sources are classified as long-term, medium term, and
short term. Ownership and control classify sources of finance
into owned and borrowed capital. Internal sources and external
sources are the two sources of generation of capital. All the
sources have different characteristics to suit different types of
requirements. Let’s understand them in a little depth through
this assignment.
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Source of finance
Sources of finance for business are equity, debt, debentures,
retained earnings, term loans, working capital loans, letter of
credit, euro issue, venture funding etc. These sources of funds
are used in different situations. They are classified based on
time period, ownership and control, and their source of
generation. It is ideal to evaluate each source of capital before
opting for it.
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Long Term Finance source

Long-term financing is a mode of financing that is offered for
more than one year. It is required by an organization during the
establishment, expansion, technological innovation, and
research and development.
In addition, long-term financing is required to finance long-term
investment projects. Long-term funds are paid back during the
lifetime of an organization.
Equity-Shares:
Equity Shares, also known as ordinary shares, represent the
ownership capital in a company. The holders of these shares
are the legal owners of the company. They have unrestricted
claim on income and assets of the company and possess all the
voting power in the company.

In fact, the foremost objective of a company is to maximise the

value of its equity shares. Being the owners of the company,
they bear the risk of ownership also. They are entitled to
dividends after paying the preference dividends. The rate of
dividend on these shares is not fixed and depends upon the
availability of divisible profits and the intention of the directors.

They may be paid a higher rate of dividend in times of

prosperity and also run the risk of no dividends in the period of
adversity. Similarly, when the company is wound up, they can
exercise their claim on those assets which are left after the
payment of all other claims including that of preference
shareholders.

Preference Shares:

Preference share capital is another source of long-term financing

for a company. As the name suggests, these shares carry
preferential rights over equity shares both regarding the payment
of dividend and the return of capital. These shares carry a fixed rate
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of dividend and such dividend must be paid in full before the

payment of any dividend on equity shares. Similarly, at the time of
liquidation, the whole of preference capital must be paid before
any payment is made to equity shareholders.

Ploughing Back of Profits:

A new company can raise finance only from external sources such
as shares, debentures, loans etc. But, an existing company can also
generate finance through its internal sources, i.e., retained earnings
or ploughing back of profits. When a company does not distribute
whole of its profits as dividend but reinvests a part of it in the
business, it is known as ploughing back of profits or retention of
earnings. This method of financing is also known as self-financing or
internal financing.

Ploughing back of profits is made by transferring a part of after tax

profits to various reserves such as General Reserve, Reserve Fund,
Replacement Fund, Dividend Equalisation Fund etc. Such retained
earnings may be utilised to fulfil the long-term, medium-term and
short-term financial requirements of the firm.

Debentures:

Debentures are one of the frequently used methods by which a

company raises long-term funds. Funds acquired by issue of
debentures represent loans taken by the company and are also
known as ‘debt capital’. A debenture is a certificate issued by a
company under its seal acknowledging a debt due by it to its
holders. In USA there is a distinction between debentures and
bonds. There, the term bond refers to an instrument which is
secured on the assets of the company whereas the debentures
refer to unsecured instruments.

But, in India no such distinction is made between bonds and

debentures and the two terms are used as synonymous.
According to Section 2 (30) of the Companies Act, 2013, “the
term debenture includes debenture stock, bonds and any other
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securities of a company whether constituting a charge on the

assets of the company or not.”

Loans from Financial Institutions:

Financial Institutions are another important source of long-

term finance. In India, a number of special financial institutions
have been established by the Government at the national level
and state level to provide medium-term and long-term loans to
the industrial undertakings.
Financial institutions established at the national level include
Industrial Development Bank of India (IDBI), Industrial Finance
Corporation of India (IFCI), Industrial Credit and Investment
Corporation of India (ICICI), Industrial Reconstruction
Corporation of India (IRCI), Unit Trust of India (UTI), Life
Insurance Corporation of India (LIC), General Insurance
Corporation (GIC) etc.

Financial institutions established at the state level include State

Financial Corporations (SFCs) and State Industrial Development
Corporations (SIDCs). For example, In Haryana, Haryana State
Financial Corporation (HFC) and Haryana State Industrial
Development Corporation (HSIDC) have been established.

Lease Financing:

Lease is a contract between the owner of an asset and the user

of such asset. Owner of the asset is called ‘Lessor’ and the user
is called ‘Lessee’. Under the lease contract, the owner of the
asset surrenders the right to use the asset to another party for
an agreed period of time for an agreed consideration called the
lease rental. The lessee pays a fixed rental to the lessor at the
beginning or at the end of a month, quarter, half year, or year.
At the end of the period of lease contract, the asset reverts
back to the lessor, who is the legal owner of the asset.
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As the legal owner, it is the lessor (and not the lessee), who will
be entitled to claim depreciation on the leased asset. At the
end of lease period, the lessee is usually given an option to buy
or further renew the lease contract for a definite period.

Leasing is, thus, a device of long term source of finance. Lessee

gets the right to use the asset without buying them. His
position is akin to that of a person who uses the asset with
borrowed money. The real position of lessor is not renting of
asset but lending of finance and hence lease financing is, in
effect, a contract of lending money. The lessee is free to choose
the asset according to his requirements and the lessor is
actually the financier.
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Medium-term Finance Source

Medium term financing means financing for a period of 3 to 5 years

and is used generally for two reasons. One, when long-term capital
is not available for the time being and second when deferred
revenue expenditures like advertisements are made which are to
be written off over a period of 3 to 5 years. Funds required for say,
a heavy advertisement campaign, the benefit of which lasts for
more than one accounting period, should be financed through
medium-term sources of finance. In other words expenditure that
results in deferred revenue should be financed through medium-
term sources. Medium-term finance can come with advantages of
both short-term finance and long-term finance, but may also inherit
their disadvantages. Medium-term finance mostly consists of loans
because equity is generally a long-term source of finance.
Medium term financing sources can in the form of one of them:

Loans from Financial Institution:

Financial Institutions are another important source of

long-term finance. In India, a number of special financial
institutions have been established by the Government at
the national level and state level to provide medium-
term and long-term loans to the industrial undertakings.
Financial institutions established at the national level
include Industrial Development Bank of India (IDBI),
Industrial Finance Corporation of India (IFCI), Industrial
Credit and
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Investment Corporation of India (ICICI), Industrial

Reconstruction
Corporation of India (IRCI), Unit Trust of India (UTI), Life
Insurance Corporation of India (LIC), General Insurance
Corporation (GIC) etc.
Financial institutions established at the state level
include State
Financial Corporations (SFCs) and State Industrial
Development
Corporations (SIDCs). For example, In Haryana,
Haryana State Financial Corporation (HFC) and
Haryana State Industrial Development Corporation
(HSIDC) have been established.

Loans from Banks:

They are generally a quick and straightforward way to

secure the funding needed, and are usually provided over
a fixed period of time. Bank loans can be capital/principal
repayment or interest-only and can be structured to
meet the business’s needs. For businesses seeking to
purchase business premises, commercial mortgages are
widely available and will, in general, offer flexible terms.
Bank loans can be short term or long term, depending on
the purpose of the loan. Bank loans are normally
provided at a cost, which is generally interest on the
owed amount. Other fees and charges may be applicable,
depending on the type of loan and on the lender.
Arrangement fees are commitment or administration
charges payable to the lender to reserve the funds and to
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cover opening costs. Fees will vary depending on the

complexity of the business, its size and risk.

Public Deposits:

Public deposits refer to the unsecured deposits invited

by companies from the public mainly to finance working
capital needs. A company wishing to invite public
deposits makes an advertisement in the newspapers.
Any member of the public can fill up the prescribed form
and deposit the money with the company. The company
in return issues a deposit receipt. This receipt is an
acknowledgement of debt by the company. The terms
and conditions of the deposit are printed on the back of
the receipt. The rate of interest on public deposits
depends on the period of deposit and reputation of the
company. A company can invite public deposits for a
period of six months to three years.
Therefore, public deposits are primarily a source of
short-term finance. However, the deposits can be
renewed from time-to-time. Renewal facility enables
companies to use public deposits as medium-term
finance. Public deposits of a company cannot exceed 25
per cent of its share capital and free reserves. As these
deposits are unsecured, the company having public
deposits is required to set aside 10 per cent of deposits
maturing by the end of the year. The amount so set
aside can be used only for paying such deposits.
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Lease Financing:

Lease financing is one of the important sources of

medium- and long-term financing where the owner of an
asset gives another person, the right to use that asset
against periodical payments. The owner of the asset is
known as lessor and the user is called lessee. The
periodical payment made by the lessee to the lessor is
known as lease rental. Under lease financing, lessee is
given the right to use the asset but the ownership lies
with the lessor and at the end of the lease contract, the
asset is returned to the lessor or an option is given to the
lessee either to purchase the asset or to renew the lease
agreement.
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Short-Term Finance Source

Trade Credit
Ooh yes, you have understood it right. It is the credit extended
by the account’s payables. We would classify this credit into 2
types – free trade credit and paid trade credit. After a particular
no. of days as per payment terms, the supplier charges interest
on the delay of payment. So, the period before this is free trade
credit and after that is paid trade credit.

It’s quite obvious that the free trade credit should be as much
as possible because it is free of cost. How much is free trade
credit extended to a customer? It depends upon the
creditworthiness of the buyer, discipline maintained in
payment commitments, the bulk of the business, etc. Higher
you rate on these factors, higher would be the free trade credit
available to your business.

Paid trade credit is definitely a type of short-term financing but

on the priority list, it would be quite below. In short, it should
be selected only when another financing is not available. The
reason for not opting for it is its high-interest cost.

Short-term / Working Capital Loans

Short term loans can be availed from banks and other financial
institutions. Banks extend these loans after careful study of the
business, its working capital cycle, past track record etc. Once
availed, these loans are repaid either in small instalments or
may be paid in full at the end of the period. This depends on
the terms of the loan. It is advisable to use these loans for
financing permanent working capital needs. There are other
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alternatives to fund the temporary working capital needs. For

more refer Working Capital Loans.

Business Line of Credit

A business line of credit, a type of short-term financing, is most

appropriate for temporary working capital needs. In this type of
financing, an amount is approved by the issuing bank or
financial institution. Within the limit of this amount, the
business can make payment and keep depositing once payment
from customers is received. It works like a revolving credit and
best part of this is the interest is charged on the utilized
amount only and not on the approved amount. The business
has the flexibility to deposit unused amount to save on interest
cost. This way it becomes a very cost-effective financing option.

Invoice Discounting

Invoice discounting is another source of short-term finance

where the receivable invoices can be discounted with the
financial institutes or banks or any third party. Discounting
invoices means the bank will pay you the money at the time of
discounting and collects the money from your customer when
the bill becomes due.

Detailed post: Invoice Discounting

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Factoring

Factoring is also a similar arrangement like invoice discounting

where the accounts receivables of a business are sold to a third
party at a price which is lower to the realizable value of the
accounts receivable. This purchasing party is commonly known
as a factor. These factoring services are provided by both banks
and other financial institutions. There are many types of
factoring like with recourse or without recourse etc.

Commercial Paper:

Commercial paper, also called CP, is a short-term debt

instrument issued by companies to raise funds generally for a
time period up to one year. It is an unsecured money market
instrument issued in the form of a promissory note and was
introduced in India for the first time in 1990.Companies that
enjoy high ratings from rating agencies often use CPs to
diversify their sources of short-term borrowings. This gives
investors an additional instrument. They are typically issued by
large banks or corporations to cover short-term receivables
and meet short-term financial obligations, such as funding for
a new project.
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Conclusion

Finance is significant for business because it cannot carry out its

operations even for a single day without finance. It is therefore
important to search the sources from where funds can be collected.
The selection of source depends upon the amount of funds
required, nature of business, repayment period, debt-equity mix,
etc. The selection of source also depends upon the purposes for
which funds are needed. A business can raise funds from various
sources. Each of the source has unique characteristics, which
must be properly understood so that the best available source of
raising funds can be identified. There is not a single best source of
funds for all organisations. Depending on the situation, purpose,
cost and associated risk, a choice may be made about the source
to be used. Sources of finance for business are equity, debt,
debentures, retained earnings, term loans, working capital loans,
letter of credit, euro issue, venture funding etc. These sources of
funds are used in different situations. They are classified based on
time period, ownership and control, and their source of generation.
It is ideal to evaluate each source of capital before opting for it.
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Reference
1) https://www.businessmanagementideas.com/financial-management/sources-of-
finance/long-term-sources-of-finance/19444

2) https://dgstudentfinance.com/qa/what-are-the-sources-of-medium-term-
finance.html

3) https://financeviewer.blogspot.com/2019/03/long-term-and-short-term-sources-
of.html