SOURCES OF BUSINESS 17 FINANCE 01 ise finance depends s sand mothods which a businoss ente rprino will use to ral naa onthe yerod sich funds ar require. ceoled iM Sa the financial requirements 0 y be classified into three categorios given Delow = ' = rt eres hase t]tis required for investment in fixed Sppale sch asad and building, plant and machinery, ete., and for nae rat ee tacea nn i fingnes is generally needed for a period often years or more. Shares, debentures, ings and loans from financial institutions are the main sources of long-term finance. ; (2)Medium-Term Finance; Itis required for investment in permanent working capital and for repayment of debts. It is raised for a period of more than one year and less than ten years, Redeemable preference shares, debentures, Joans from financial institutions, term loans from banks and public deposits are the sources of medium-term finance. is required for purchasing working assets and for meeting day-to-day working capital needs of business. It is raised for a period of 12 months or less, The main sources of short-term finance are trade credit, public deposits and commercial banks. Business Finance Long term and Short term Medium term Finance Finance ‘Issue of Shares Trade credit Issue of Debentures Bank credit Institutional Financing Instalment credit ‘Public Deposits Factoring Ploughing Back of Profits Customer Term loans from Banks ‘Advance Sources of Finance ISSUE OF SHARES A company can issue two types of securities : (i) ownershi iti i shares and preference shares constitute the ow: ee oe nership securities (ii) erediterchi ‘0 or debentures. The owned capital of a company is epllt into a lara eeatorship ee Parts, Each such partis known as a share. A shara is a unit of a member's interest in the capital of the company. Share eapital provides the permanont buen ween eee structure, It constitutes the risk capital, Shares aro general; ee (a) Preference shares ; and 'y of two types : (b) Equity shares. Scanned with CamScannerSource rees of Business Finance feronve Shares : Preferonce shar a . ‘es are the __ Proth regarding the dividend and # shares whieh be pad on preferonce before any he roturn of enpltal, Pleat, dloidend nig erat gost rvinding up of the company, prof lend {8 paid on equity ahures, Hecnn Nae eae enoteharalacee sharoholders:inunt be paid beck ate ete ee aay at ven thei intorenta eda se bterance share hark thelr capital ists 8 are directly affecte ren do notearry any vtiny preference shares can be of the following t a 1. cumulative and non-cumulative fiat 1 Ca oe dividend nol pala a reterence shares ¢ Sn cane of cumulat Compal dividends go on eciniuladlegeed ee year is carried forward to the ae pe Bar Such arears of dividend must be paid bofare avid able out of the profits in eubasryent Onnon-cumulative preference shares divide Bae oe teeta got declare dividend in any year, the right ana not accumlate, In cas the cnpany at declare dividend in any Year the ight ta dividend in reaped ofthat yar et for {rides of Assotiation, all preference shares a Nae ae ceria stated in the 2, Participating and non: —_ ‘ “partici epee eee lipating Preference shares : Participating roar dividend to prefarence and enulty shatekeldere This havea inad Nanna Fadend. On the contrary, the holders of neepart sain raterered hanes do at eiay er sana a tan erpide ome ep alr ge ie eel asco T Convertible and non-eonvertible preference aharen « Holders of convert petrence shares 7 get such shares converted into equity shares after ot od arto oe e other hand, preference shares which cannot be eonverted i it e a ensnvertible preference shares, Unless otherwise aed aeteeae sharon a deemed to be non-convertable. Preference een 4, Redeemable and Irredeemable Preference Shares : The holders of redeemable preference shares ean be refunded their capital ater the expiry of apecitied period or atthe deri ofthe company. Only company limited by shares can issue redeemable preference thes. Tho intention to return the money should be made clear when the hares are issued. e Companies (Amendment) Act, 1988 lays down that a public company limited by shares cannot issue preference shares which are irredeemable or redeemable after the expiry of more than 10 years. Preference ahares are a hybrid security comprising features of both equity shares and debentures, Like debentures they carry a fixed dividend and enjoy priority over equity shareholders but no voting right. Like equity shares dividend on preference shares is payable only when there are profits. Advantages of Preference Shares noiAppeal to cautious investors who look for reasonable safety of their ca ¢htainable on debentures. __2.No burden of profits Preference shares do not put a fixed burden on finances as ividends are payable only out of| ‘profits. 3.No interferance in managements Generally, preference shares do not carry voting . Therefore, promoters can retain: exclusive ‘contol over the company by issuing rence shares to outsiders. char No charge on assets + lasue of, for 18290 the assets of the ‘company. The com} Taising loans in future. S£8 #FE SELL = MT EEE Preference shares greatly appeal to those investors pital along with a fixed but higher return than that shares does not involve any mortgage or preference can keep its fixed assets free to be used pany Scanned with CamScanner200 SBPD Publications Buatnena Organtoation _————_. , jorance shuren $9 fixed, When 4p 5, Trading on oquity ¢ Rato of dividend on proference 1 x ; company’s curnings rise, the company ean pay higher raten of dividend to equity sharcholdiy Proferonco shares aro an economical nource of finance bocuune the rate of dividend jy Usual) low, 6. Floxibility ¢ In cano of redeomable proferonco shares the amount can he pnd yy and whon the company doa not need It, Participating or convertible preference sharey ey bo issued to attract invertors who want to share In tho growlng prosperity of the Disadvantages of Proforence Sharos 1. Limited appeal t Proferonce shares havo no appeal for Inventors who want to ta risks. Moro cautious and orthodox invastors alao do not like them, as return on such shar is uncertain and irregular, In ordor to attract invontorn tha company In forced to offer higher rates of dividend on preference shares, Tho isnue of preference shares is yencrally conthie, than debentures, Soveral legal formalities are involved in the innue and redemption preference shares, 2, Fixed liability t Dividend on preference shares has to ho paid at a fixed rate befor itis paid on equity shares, In caso the company's earningy aro inadequate, very little might be lef for equity sharesholders, Such Nability becomes all the more burdensome in the of cumulative preference shares, Issue of preference shares may alvo affect the cal worthiness of a company, 3. Lack of votin, # COM pany| & rights : Preference shares do not carry voting rights in the normal gourse. When the company’s earnings rise rapidly, holders of such shares do not got ashen in the prosperity of the company except in case of participating preference shares, 4. Fear of being shown the door + Holders of redeemable preference shares have to face yet another unpleasant prospect, The company raises capital from them when it is badly in need of funds. But once its purpose is served, i bids goodbye to them by paying back their money. Preference shares are unpopular due to low rate of return, ind absenco ofa voice in the management of the company. However, preference shoves ‘may by a useful source of eapital for a company under the following eonditione (i) When the assets are not acceptable as suffi uncertainty as to its payment icient collateral security for issuing debentures. Gi) When higher interest will have to be paid by issuing debentures against assets which are already mortgaged, (ii) When the company's prom: obligation as to payment, (iv) When the company necds funds for medium-term it can issue redeemable preference shares, (v) Preference shares can be issued as a bonus for increasing the sale of other shares. Equity Shares Shares which carry no preference rights of priority in the payment of dividend and in the repayment of capital are called equity shares or ordinary shares. Equity sheres are issued prior to other securities and repaid in the last, Divi only when there are profits and the dividends after paying dividend on preference shares, In the equity shares are paid after all other claims are repaid. But holders of equity share enjoy full voting rights and share the residual profits, Equity shareholders Provide the ‘risk capital’ or ‘venture capital. Thus, equity shareholders are the real risk bearers and controller of a company. joters want to retain control without creating fixed vent of winding up of the company. Scanned with CamScannerSoi urces of Business Finance — s of Equity Share; = nl Li No burden of finances : Equity share, ea venture capital, adequate profits, ie -term finance : Equi 2, Long: *Mquity share capital is refund indi ecompany Therefore, equity capital remains with the aoe a oa at irene ital ofthe company. yy for ever. It is permanent s,No charge on assets : Equity shares do not ets of the aan The company is free to use its Property for raising loans, 4 Source of st igre bitin wy, ith substantial equity capital commands prestige ibe investment m ~ its ability to borrow is high. Equity shares are the foundation of yompany’s financial structure, 5, Small nominal value : The face val sesult equity shares have a wide appeal an anbuy them. 'ue of an equity share is generally very low. As d even persons belonging to low-income groups 6. Attractive to enterprising investors : Equity shares are ideal for bold and sdventurous investors who like to take risks in the hope of higher returns. Holders of such sures enjoy benefit of capital appreciation and claim to new issue of equity shares. They tbo enjoy full voting rights, Disedvantages of Equity Shares 1 Manipulation of control : Equity shares carry full voting rights. They form the cleus of control. This gives rige to many undesirable practices by persons who seek to jaincontrol over the company. Often there is cornering of votes and manipulation of control tydiques of shareholders to their own advantage. . 2. Danger of over-capitalisation : Capital raised through equity shares is not nfundable during the lifetime of the company. Mistake in estimation of financial requirement overenthusiasm may lead to over-capitalisation resulting in lower rate of earnings and dividends. Financial structure becomes inflexible. 3. No trading no equity : When the entire share capital is raised through equity dares, the benefit of trading on equity is not available. 4. Perpetuation of control by a few : Any new issue of equity shares has to be first ‘ered to the existing shareholders. As a result the company continues to be managed by a ‘andful of persons, Ordinary and small shareuolders remain owners in name only. 5. High risk : Equity shareholders sink or swim with the company. Dividend and “fund of capital are both uncertain, Often thereis speculation in the prices of equity shares. fore, equity shares do not appeal to cautions interests. Mcreover, equity shares are a ®etly source of finance and dividend paid are not deductible for tax purposes. tures Debenti ing by a company and represent its loan capital. Debenture hear credit oa ‘A debenture is a document or certificate issued by a ‘ any as proof of the money lent to it by the holder. Itis an acknowledgedment ofdebt as ‘llas an undertaking to repay the specified sum with interest on or before the prescribed le debenture ie a certifieate jesucd by a company under its common seal ag “\ovledgement of debt with or without a charge on the company's assets. Interest on = ~_ Scanned with CamScanner262 SBPD Publications Buaineas Organisation periodically until the maturity and repa, debentures is paid nt a fixed rate and it is pay able rally involve a harpeen a of debentures. Dobontures carry no voting rights but they gene company’s assets. con Shares and Debentures Pe mcenstanen ant points of distinction between shares and debentures ; 1, Status of holders : Shareholders are part owners of a company white debenturcholders are simply its creditors, A share is an ownersl ip ecu ity and it forms part of the company’s owned capital, But a debenture is a creditorship security and it form che company’s borrowings. ree yield : Shareholders are paid dividend when there are profits and dividends are declared. But debenturcholders are paid interest irrespective of profits. 3. Nature of return : Dividends fluctuate with the quantum of profits. They are irregular and uncertain. On the other hand, rate of interest on debentures is fixed and regular. Thus, the quantum and frequency of return are different. 4. Collection of funds : The debenture money is collected by the company generally in alumpsum. But share nioney is normally collected from shareholders in instalments, 5. Security : Shares are issued without any mortgage or charge on the company’s property. Debentures are normally issued against the security of certain assets. A share is always unsecured but a debenture is generally secured. 6. Conditions of issue : There are no restrictions regarding the terms of issue of debentures. But shares can be issued at a discount or at premium only subject to certain conditions prescribed under the Companies Act. 7. Claim as to return : Dividends cannot be claimed as a matter of right. But interest can be claimed as a matter of right. 8, Voting rights : Shares carry voting rights and shareholders have the right to Participate in the management of a company. Debentures carry no voting rights in the normal course and debentureholders do not participate in the management of the company. 9. Redeemability : Except redeemable preference shares, share capital is refundable only av the time of winding up. Debenture amount is normally refunded before the winding up. Debenture money must be repaid in accordance with the terms of issue. But redeemable preference shares cannot be repaid without legal formalities, 10. Order of repayment : At the time of winding up, ] debenture-holders must be repaid before shareholders. Share capital i i it ether erodes ee nal ital is repaid after claims of debentureholders and 11. Taxation : Interest paid on debe itures i il ring ii tax. But dividends are not so deductible, tbe ftom profits for charging income Kinds of Debentures Debentures issued by a company can be of the followi following types : = Sere si enturca 2 ig or unsecured debentures are not secured x ‘gaged on their issue. On th ortgage secured debentures are issued by creating a fix fs citer band, m e In case, the company makes a default in peyrcey eootine chase on the company’s asets dues from the mortiaeea roma It in payment, the debentureholders can recover their 2. Red As empvnanene ee debentures: Redeemable or callable debentures the company, But rede potual time Prior to their maturity at the option of winding up ofthe company. °° PerPetual debenture Scanned with CamScannerSources of Business Finance . Bearer and Registered debenture, syelivery 48 no record of auch debentures eee debenture meet! formalities are required for their transfor y is necessary, Debent mpany is ¥ ure Coupons are attached with auch debentures. The holders Py debentures can claim int i rail orest by fill i feat istered debentures nro recorded aa ie ion sending the coupons to the company. rable only tothe registered holder. Such debentutoscen ge nose olders. Interest in ‘onvertible and non-conve A tureholders are given the auel® debentures: In case of convertible debentures, the ‘specified period and on certal convert their debentures into equity shares Oe det aia can ‘i in conditions. This serves as an incentive to the debenture! 1 In course of time participate in th fits and mpany.,Non-convertible debentures di Te ee naeamiens of ween do not carry any right to be converted into equity Advantages of Debentures 1, Trading on equity : Interest on debentures is paid at a fixed ra inerease in profits can lead to higher rate of dividend 0 equity shareholders abieaaitabitd 2. Economical ; Raising of funds through debentures is cheaper as compared to shares. Debentures are a safer investment and, therefore, they can be issued at a rate of interest lower than the rate of dividend. Underwriting commission, brokerage, etc., are also comparatively low. 3. Appeal to cautious investors : Debentures can be issued to raise capital from those investors who want a fixed and regular income without undue risk. Debentures provide greater security and a fixed return unaffected by the company’s profits. They often carry a charge or mortgage on the company’s assets. In case of default by the company, the debentureholders can recover their dues from the mortgaged assets. This helps to protect the interest of debentureholders. 4, Flexibility : A company can issue redeemable debentures to meet its medium-term needs, It can repay the debenture money when it does not need them any more. In this way, it can avoid the danger of over-capitalisation. Debenture capital can be repaid from the earnings of the company. 5. Tax relief : Interest paid on debentures is allowed as a deduction while computing the taxable income of the company. This results in saving in income-tax. 6. No interference in management : Debenturcholders do not enjoy voting rights and as a result they do not interfere in the management of the company. The shareholders can retain the control in their hands by purchasing debentures. Disadvantages of Debentures 1. Fixed burden on earnings : Interest on debentures has to be paid irrespective of Profits. During periods of depression, it may become a heavy burden on the company’s earnings, 2, Loss of Prestige : Issue of debentures generally involves a charge on assets. As a Tesult the credit-standing and borrowing capacity of the company is reduced. It may have to Pay higher rate of interest to borrow from banks and financial institutions. 3. Charge on assets : In order to sell debentures, a company has normally to create a charge or mortgage on its assets in favour of debentureholders. 4. Limited appeal : Debentures are not an attractive investment for most of the investors. They carry no voting rights, no right to share in the prosperity of the company 8nd limited marketability. 263 8 can be transferred by ‘opt in the Register of Debentureholdera, 4nd no formal notice or intimation to the Scanned with CamScannertoincrease tne popularity of debentures in the country. i . Com pan Sent Kavity Shares, Preference Shares and Debentures niny i ssi : choice of securitjes to be issued. This decision a edneeena decisions to be made ia the ty parative evaluation of various types of securities. Often a company may choose all the securities. In order to determine the suitability of shares and debentures for a company, the following factors should be taken into consideration : 1, Cost : Equity shares are a costlier source of finance than prefrence shares and debentures. Equity shareholders expect a higher return to compensate them for the higher risk which they bear. Debenture interest is deductible from profits for income-tax purposes. 2, Period of Finance : Equity shares provide long-term finance for the lifetime of the company. It has not to be repaid before the winding up of the company and serves as the risk capital. Preference shares and debentures provide long-term and medium-term finance. Funds received through these securities can be paid back whenever the company desires. 3. Risk ; Return on equity shares depends upon the profits and involves no fixed burden on the company. Issue of equity shares involves no risk of insolvency even if the company fails to earn sufficient profits. But dividend on preference shares and interest on debentures represent a fixed burden on the company. Ifthe earnings are uncertain and irregular, equity shares should be issued, But when the earnings are fairly regular and high, debentures may be issued. 4. Trading on Equity : Ifa company issues only equity shares, there is no scope for tradingon equity. Use of non-participating preference shares and non-convertible debentures helps to increase the return to equity shareholders. 5, Control on Management : Equity shareholders have full voting rights in the meetings of a company. Therefore, issue of equity shares may dilute control of the ‘company’s aifairs. Preference shares and debentures carry limited or no voting rights. When the company does not want to diffuse control, it is advisable to raise further capital by issuing preference shares and debentures. 6. Capacity to Borrow : The i .gsue of equity shares increases the capacity stag company to its creditworthiness is increased. But issue of debentures reduces the Se ame te to borrow funds. Issue of preference shares has no significant effect on the borrowing capacity and creditworthiness ofthe company. ; 7. Flexibility of Financial Structure: Equity shares provide freedom for the issue ofother securities but make the capital structure rigid as equity capital cannot be paid back in the normal course of business. Preference shares and debentures can be redeemed and, therefore, help to bring elasticity in the financial structure of the company, 8. Appeal to Investors : Equity shares are attractive to enterprising investors who are ready to take risk and want appreciation of their investment, Preference shares and debentures can be issued successfully to the investors who are cautious and want a fixed Scanned with CamScanner266 SBPD Publications Business Organisation return on their holdings. A company may issue all the three types of securitios to raise funds from different types of investors. “ | A.S. Dewing has laid down the following rules regarding the issue of shares and debentures : - : (a) Debentures or bonds should be issued only when the future earnings are liberal and reasonably constant. . (b) Preference shares may be issued when the earnings are irregular but when averaged over a period of years give a fair margin over preference dividend. ; {c) Only equity shares should be issued when the earnings are uncertain and unpredictable. Underwriting When a company makes an issue of shares or debentures, it is not quite sure that public will subscribe for the entire issue. In order to ensure that the entire issue is sold out, it makes an arrangement known as underwriting. Underwriting has been defined as “an agreement entered into before the securities are brought before the public that in the event of the public not taking up the whole of them or the number mentioned in the agreement. the underwriter will, for an agreed commission, take an allotment of such part of the shares as the public has not subscribed for.” In other words, underwriting is an arrangement between the issuing company and a financial agency known as the underwriter under which the later agrees to buy that part of the issue which isnot subscribed to by the public in consideration of a specified commission. This commission is called underwriting commission. It may not exceed 5 per cent on shares and 2.5 per cent in case of debentures. Underwriters get their commission irrespective of whether they have to buy or not a single security. Firm underwriting : Sometimes, the underwriters apply firm for a block of securities which is known as Firm Underwriting’. Under this arrangement, the underwriters agree to take up and pay for this block of securities as ordinary subscribers in addition to their commitment as underwriters, The underwriter need not take up the whole of the ‘securities underwritten by him’. Suppose, an underwiter has underwritten the entire issue of 5 lakh shares offered by a company. In addition, he has applied for one lakh shares for firm allotment. If the public subscribes to the entire issue, the underwriter would be allotted one lakh shares even though he is not required to take up any of the shares. Syndicate Underwriting : When two or more agencies or underwriters jointly underwrite an issue of securities this is known as ‘syndicate underwriting’. Such an arrangement is entered into when the total issue is beyond the resources of one underwriter or when he does not want to block up large amount of funds in one issue. An underwriter underwriting This is done to diffuse the risk involved in underwriting. Underwriters may be commercial banks, public financial institutions, investment trusts, insurances companies and stock brokers, The name of every underwriter is mentioned in the Prospectus along with the amount of securities underwritten by him. In case the issue is fully eubseribed by the public the underwriters will have not to buy a single security. Otherwise they will bewr the liability in Proportion to the amounts underwritten by them, Suppose that an issue of one lakh chwves of Rs, 10 each was underwritten by A (40,000), B(40,000) and C (20,000) Ifthe public subsribes for 70,000 shares, the underwriters will take up the remaining 30,000 shares in the ratio of 4:4:2, But they will get underwriting commission on Rs, 4 lakh, Rs. 4 lakh and Rs, 2 lakh Scanned with CamScannerSources of Business Finance 267 Thus, underwriting is a device to ensure the success of issues of securities. It has gained great importance with the growth of the corporate sector. Importance of Underwriting Underwriting of securities has gained great importance in recent years. The benefits of underwriting are as follows : (i) Underwriting relieves the promoters or management of the company of the risk and uncertainty of marketing the securities. The issuing company is assured of the availability of funds. It can make contracts for the purchase of assets. (ii) Underwriting helps in the financing of new enterprises and in the expansion of existing projects. Important projects are not delayed for want of funds. ° (ii) Underwriting builds up investors’ confidence in the issue of securities. The association of trustworthy and well-known underwriters lends prestige to the issue and investors feel that issue is sound enough for profitable investment. Issues of securities underwritten by reputed underwriters receive better response from the public. (iv) Underwriting facilitates the geographical dispersal of securities. Usually, the underwriters maintain contacts with investors throughout the country. (v) Underwriters have an intimate and specialised knowledge of the capital market. They offer valuable advice to the issuing company in the preparation of the prospectus, time of floatation and the price of securities, etc. Underwriters also provide publicity service to the companies which have entered into underwriting agreements with them. FAMEP ema rr rama Scanned with CamScanner268. SBPD Publications Business Organisation on regular basis. The amount of new issues underwritten as percentage of the amount offered to the Public increased from 18% in 1956-57 to 88.3% in 1976-77 and 98.2% in 1996-97. Ploughing back of Profits (Self-Financing) oe Retained earnings represent that portion of a company’s net profits which is kept in business for investment purposes and not distributed among the shareholders as dividend, Retained earnings or ploughing back of profits refers to the process of retaining a part of net. Profits for investments in business, Well-established companies commonly use retained earnings or undistributed profits to finance their business needs. They build large reserves out of profits. This method is also known as ‘self-financing’ because it is an internal source offinance. Retained earnings are a popular source of finance for modernisation and expansion Programmes. Such earnings can also be used to redeem old debts and to meet working capital requirements. It is an ideal source of finance. The amount of retained earnings in a company depends on several factors. Generally, more are the net profits ofa company, greater is the capacity to plough back profits. Secondly, dividend policy of the company determines the extent to which profits can be retained for reinvestment in business. A company which follows a policy of paying liberal and regular dividend every year may not be able to retain as much profits as a company following a conservative dividend policy. Thirdly, the age of the company affects the practice of self- financing. New companies generally do not retain much profits due to their desire to satisfy the shareholders. On the other hand, an old company may distribute only a small part of the profits among shareholders and may retairi the major part for ploughing back. Lastly, the future plans of the company regarding modernisation and expansion also have an influence on retained earnings. / Ploughing back of profits offers the plowing benefits ; (i) It is the most convenient and economical method of finance. No legal formalities are involved and no negotiations are to be made. No return is to be paid on retained earnings and no fixed obligations are created, (i) The financial structure of the company remains fully flexible. No charge is created against the assets and no restrictions are put on the freedom of management to raise further france by floating new securities in the market, (ii) Ploughing back of profits adds to the financial strength and credit-worthiness of the company. A company with large reserves can face unforeseen contingencies, trade cycles and capital market crisis with ease and economy. profitscan be used to stabilise the rate of dividend on equity shares Regular atieome nek tp improve relations with shareholders, (i) Use of retained earnings dose ten eae Voting eontrol of the company. (vi) Reinvestment of earnings helps to inewean ve oeen formation which is necessary forthe rapid economic development of the essunen Excessive ploughing back of profits may result in the following drawbacts; () The management ofa company may notalwaysuse the retained earnings ithe Genoa ent gharoholdero, It may invest them in unprofitable elds or may spend thew wear ange ta Too much dependence on retained earnings may tempt the manayemeen (ene shares to the equity shareholders. Frequent capitalisation of profits may result in over- capitalisation (ii) The practieof ploughing back of profits may be used ter ere prices on the stock exchange. V; i . deceive genuine and uninform Scanned with CamScannerSources of Business Finance = use afrelsined earnings may result in monopoly and concentration of economic power in a few lu institu " Tia ee tecmmarsial banks in the field of long-term finance to industry yas been NCE » the Government has set up a number of special financial tutions in the country to provide long. f yatta ‘I e : #-Lerm finance to business enterprises. The IFCI, BI, ICICL, SFCs are the main a ti fe 7 appl, ICT, SACS are the main among auch financial intititions. There term-lending institution ai ea mi a ee have become a major source of finance for floatation of sews concerms as well as for the modernisation and expansion of existing concerns. They eupplement other sources of finance and fill gaps. They provide finance both in the form of equity and debt. These institutions provide both direct (loans) and indirect (purchase and underwriting of securities) assistance. These institutions are not simply financial institutions. They also provide promotional, technical and managerial services. They take initiative in Jocating and filling gaps in the country’s industrial structure, In addition to, well-known development banks in the country, the LIC, General Insurance Corporation. NSIC, etc., also help in providing finance to industry. The main advantages of institutional finance are as follows : (i) Roth risk as well as loan ailable. Special financial institutions provide underwriting and direct subscription facilities also. (ii) New companies which may find it difficult to raise finance from the public can get finance from these institutions. Assistance is available when recourse to normal sources is impracticable or unprofitable. (iii) As these institutions carry out a thorough investigation before granting assistance to a concern, relationship with them helps to increase the credit-worthiness of a company. (iv) Loans and guarantees in foreign currency and deferred payment facilities are available for the import of required machinery and equipment. (v) The rate of interest and payment procedures are convenient and economical. Facilities for repayment in easy instalments are made available to deserving concerns. (vi) Along with finance, a company can obtain expert advice and guidance for the successful planning and administration of projects. However, institutional financing may involve the following limitations : (i) The concern requiring finance from sf° cial financial institutions has to submit itself to a thorough investigation, A number of formalities and documents are involved. (ji) Many deserving concerns may fail to get assistance for want of security and other conditions laid down by these institutions. (iii) Sometimes, these institutions place restrictions on the autonomy of management. They lay down a convertibility clause in loan agreements. In some cases, they insist on the appointment of their nominees on the Board of Directors of the debtor company. PUBLIC DEPOSITS ‘The term ‘public deposit’ implies any money received by a non-banking company by way of deposit or loan from the public including the employees, customers and shareholders of the company other than in the form of shares and debentures. Buble ce nee been apceulinr feature of industrial finance in India, Companies have been receiving public deposits forn long time in order to mect their medium-term and long-term requirements for rioaacsh The practice of accepting public deposits developed during the initial decade of ano century. At that time banking facilities in the country wort not well-developed. People ith the reputed business concerns due to the higher rate Preferred to deposit their savings W! of interest “offered by these concerns ‘and due to Jack of faith in the banks. The system of public deposits was very popular in the cotton textile mills of Bombay, Ahmedabad and Sholapur and in the tea gardens of Assam and Bengal, 1 Financing Scanned with CamScanner270 SBPD Publications Business Organisation In recent years, the method of raising finance through the eublle, eee again become popular for various reasons. Rates of interest. offered by nar orbareoal an those offered by banks, At the same time the cost of deposits is less than ne erorings from banks to the company. Companies generally accept public ee ees ie imum Period of one year and for a maximum period of five years However, - : posits can be renewed from time to time. Companies intending to invite deposits advertise 7 newspapers and take the help of stock brokers. Any one can fill up the specified form an nr it the money with the company. The company, in return, issues a deposit receipt which 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 interost on deposits varies from 11 per cent to 15 per cent depending on the period of deposit and reputation of the company. F While accepting public deposits, a company must follow the provi sions of the Companies Act and the directions issued by the Reserve Bank of India, According to the Companies (Acceptance of Deposits) Rules, 1975 as amended in 1984, no company can receive secured and unsecured deposits in excess of 10 per cent and 25 per cent respectively of paid up share capital plus free reserves, The Central Government has laid down that no company shall invite a deposit unless an advertisement, including a statement showing the financial position of the company, has been issued in the prescribed form. Under the new rules, deposits cannot be invited for a period of more than five years. However, deposits can be renewed, The rate of interest payable on deposits must not exceed 15 per cent per annum. In ordes to repay the deposits maturing in a particular year, the company must deposit 10 per cent of the deposits with a scheduled bank or in specified securities, Companies accepting public deposits must regularly file returns giving details of such deposits, Since April 1, 1980, Public sector companies have also been permitied to invite public deposits, As a source of finance, public deposits offer the following advantages (i) The interest payable on public deposits is lower than interest charged by banks ant special financial institutions. Interest paid on deposits is a deductible expense for income tax Purpose. (i) Administrative cost of deposits is lower than that involved in the issue of shares and debentures. The procedure of inviting public deposits is simple and lesser formalities are fixed the company can derive the benefits of trading Scanned with CamScanneras Sources of Business Finance —_—— may use the deposits as it likes, = ; iW ran nies and those with uncertain eon nue deposits are generally not available to new the growth of a healthy capi in earnings. (v) Widespread pital S pread use of public dé i ire earth of sound industrial noverafes @iatore the Interest pielectraaanpiier a i securities A " ered: planning and plan prioriti spurt in public deposits ma: faves in such deposits as there i fd fovernment. (vi) Professional imeeer dso ee several legal restrictions now on public deposi capital appreciation. Moreover, there are : HIRE Hire purchase is a type ofinstalment an hirer, agrees to take the goods on hireat at it under which the hire purchaser, called the of principal as well as interest, with an op tated rental, whichisinclusive ofthe repayment oper liro purchase cee esas option fo purchaee. The Hire Porchase Act, 1972 esis tic hises hasan rund eee under which goods are let on hire and under Tadinchides an agreement under whist oe eee (Possession of goods is deliv. such person pays the agr. sidepael by frp noe ‘a person on condition that (i) The property in the goods i : iments, such instalments, and to pass to such person on the payment of the last of Gi) Such i i iii) fe oe hneson has a right to terminate the agreement at any time before the property Hire purchase should be distinguii i f guished fro i shpat the pay of eis intalment,Botincateothive purchase ownership remains with the scller until the last instalment is paid. Hi iffers from leasing. In a lease agreement no option is provi reper eee is co Ownership remains vested in the whee lessor) caroaphonten Sree eae ; Ownershinn ; and the hirer is given no authorit sequte title except in case of perpetual lease. _ nitially, manufacturers and dealers themselves financed hire transacti : ; a purchase ions. Subsequently, commercial banks, publi financial institutions, eg., ICICI, IDBI, ete. ‘and re purchase companies started offering finance for hire purchase deals. és There are usually three parties involved in a hire purchase transaction : Gi) ‘The dealer who selle yvods on hiro purchase basis. Gi) The customer who buys goods on hire purchase basis (hirer). ii) The finance company which prov es finance for hire purchase deals. Ahire purchase agreement is made between the dealer and the hirer. The agreement contains terms and conditions, total amount, initial payment to be made by the hirer, tenure of hire purchase, periodicity of payment, number of instalments, te, The dealer receives the bills of ‘exchange from the hirer. The dealer than discounts the bills with the fance company. The finance company collects payments of bills from the hirer, Small-scale firms can acquire industrial machinery, office equipment, vehicles, etc., through hire purchase without making full payment. ‘With the help of assets acquired through hire purchase they enn produce and sell. From the earnings payment can easily be made in instalmenta, Ultimately the ownership of assets can be acquired. ‘TERM LOANS FROM BANKS In recent years, commercial banks have started ‘term lending’. A term loan is aloan Sranted' for periods ranging from 8 to 7 years. Industrial Development Bank of India, increasing deposits and institutional arrangements for investigation and appraisal have Scanned with CamScanner.s8 Organisation 272 SBPD Publi enabled the commercial banks to grant medium-term finance on Laas Banks provide sufficient finance in particular to small scale units in the priority : . . : Many a times the short-term credit granted by banks is converted a m 7 jum term finance through renewal from time to time. In addition banks now provide underwriting facilities and invest in the securities of industrial concerns. aclu . While granting credit, a commercial bank generally takes into consi a © folowing factors : (i) nature and size of the enterprise, (ii) financial soundness of the concern, (ii) profitability of the business, (iv) quality of management, (v) ability to repay its loans, (vi) technical and commercial feasibility of the project, (vii) security offered by the business unit, Generally, banks insist on security while granting credit facilities to business firms. The security is provided in the form of pledge, mortgage or hypothecation. The main types of security accepted by banks are : (a) goods or stock in trade : (b) documents of title to goods, eg., Bill of Lading, Railway Receipt, Warchouse Receipt, cte.; (c) fixed deposits; (d) life insurance policies; (c) stock exchange securities; (f) real estate; (g) book debts. Term lending from banks offers the following advantages : (i) it is a flexible source of finance as loans can be repaid when the need is met : (ii) finance is available for medium. term and for a definite period; (iii) banks keep the financial operations of their clients secret; (iv) less time and cost is involved as compared to issue of securities; (v) management retains the control of the company as banks do not interfere in the internal affairs of the borrowing concern; (vi) loans can be paid in easy instalments. : : Term-loans suffer from the following drawbacks : (a) funds are available only for a few years; (b) banks require personal guarantees or pledge of assets; (c) terms and conditions + are in many cases, restrictive and cumbersome. SOURCES OF SHORT-TERM FINANCE (or Working Capital) Short-term financing involves the raising of funds for a short period, i.e., less than one year. It is raised and paid back within a year. Such finance is required to meet the short- term working capital needs of business. However, regular or permanent working capital is raised through long-term and medium-term sources. The main sources of short-term finance are trade credit, commercial banks, instalment credit, accounts receivable financing and customer advance. ‘Trade Credit Trade credit is the credit extended by one business firm to another as incidental to sale or purchase of goods and services. It is also known as mercantile credit. Trade credit may be defined as credit extended by sellers to buyers at all levels of the production and distribution process down to the retailer. It does not include consumer credit or instalment credit. It arises out of transfer of goods and is unsecured. Trade credit is usually granted for periods ranging from 15 days to three months. The buying firm receives supplies without paying immediately. Trade credit reflects the buyer's power to purchase now and pay later Tt also indicates the seller's faith in the buyer. Trade credit is available in the ordinary course of business and no security is required for getting it. The amount and terms of credit available depend upon the financial strength and goodwill of the b i 7 uyers, the custom of trade, financial resources of the supplier, the amount and frequency of purchases, degree of competition it the market, location of the customer, the naturo of products, ete eee ent te not make available the funds in cash. } ote. Trade credit does not Trade credit is a very simple and convenie) ‘A formalities are involved and the credit is ron arate eee bs ee No era . ‘ usiness interest is payable and no security is to be paid. It is a flexible source of finance as no charge Scanned with CamScannerSources of Busine: Finance 273 SS Le a ae jgereated against the assets of the company, Trade credit is more economical than bank ans. However the prices charged for credit sales are usually higher. The supplier has to fear oss of bad debts in addition to the costs of administering credit accounts. He requires larger working capital to supply goods on credit. The buyer losses cash discounts. Bank Credit Commercial banks serve as the single largest source of short-term finance to business frms. They provide following types of short-term finance : 1, Outright Loans : A loan is a direct advance made in lump sum which is credited to a separate loan account in the name of the borrower. The borrower withdraws the full amount in cash immediately and undertakes to repay it in one single instalment. The borrower jsrequired to pay the interest on the whole amount from the date of sanction. Loans may be secured or unsecured. Loans granted for some immediate need, eg., to hold stocks, are known as transaction loans. These are usually secured by pledge of specific assets which are in the actual or constructive possession of the bank. 9. Cash Credit : It is a formal and revolving credit agreement under which a borrower js allowed to borrow up to certain limit. Unlike a loan, it is a running account from which the amounts can be withdrawn from time to time, subject to the maximum stipulated amount. Cash credit is of two types. When the cash credit is not backed by any security, it is known as clear cash credit, Under it, the borrower submits a promissory note which is signed by two or more sureties. In case of secured cash credit, the borrower is required to give security inthe form of tangible assets or guarantees. In both types of cash credit, the borrower has to pay interest only on the amount a:tually utilised. 3, Line of Credit : It is an informal arrangement under which a customer can borrow up toa specified limit. The maximum amount known as the ‘limit’ is determined according te the financial position of the borrower. Line of credit is available to firms of high credit- standing only. It avoids the need to negotiate credit again and again and paying interest on idle (unutilised) money. Interest is charged only on the money actually withdrawn. 4 Overdraft :t isa kind ofa temporary financial accommodation extended by a bank to its regular customers. Under this arrangement, a customer having @ current account with the bank is allowed to overdraw from his account. Business firms use this arrangement to meet temporary shortage of funds. ? 5. Discounting of Bills : This implies procuring cash from a bank in| exchange for credit instruments like bills of exchange, promissory notes and hundies. Banks buy these instruments at prices lower than their face value the difference being the discount. Bank credit is flexible as it can be repaid whenever it is not needed. Business concerns find it useful to raise short-term finance from the banks as banks maintain utmost secrecy of thes siete affairs, They do not interfere in the management of the borrowing concerns. Banks provide financial assistance in serveral forms s0 that the borrowing firm can choose the type of assistance to suit its own requirements, But bank credit has certain limitations The duration of bank credit is very short and there is no certainty of its renewal, Sometimes, commercial banks insist on the security of tangible assets and keep wide margins. Despite these Himitations, business concerns find it convenient to approach commercial banks for Fa ea ons ities, Bank borrowings account for about 50% of the value af inventories in general : Instalment Credi : : Tratadiment erodit refers to the facility of buying machinery, equipment and other durable g00ds on eredit. The buyer has to pay # part of the price of the asset at the time of delivery Scanned with CamScannerions Business Organisation and the balance is payable in a number of instalments, The supplier charges interest on the balance due and the interest is included in the amount of instalment itself. Some suppliers provide instalment credit through finance companies and commercial banks. A business firm may also buy fixed assest on hire purchase basis. Under this arrangement, the ownership of the assets remains with the suppliers untill all the instalments are paid by the buyer, Purchase of fixed assets on instalments and hire-purchase basis enables a business firm to utilise the asset and make payments out of the earnings made from such use. Inter Company Loans In order to meet its short-term requirements, a company may borrow funds from other panies under the same management. Such borrowings are known as inter-company loans. No interest is payable on such loans and no charge is created on assets. Moreover, it is eady to obtain such loans. But the Companies Act has laid down several restrictions on inter-company loans. The total amount of loans granted by a public company to other companies under the same management cannot exceed 20% of its paid up capital and free reserve, In case of other companies this limit is 30 per cent. Leasing ! _Leasing is comparatively a now source of short-term finance. Under this method, a business enterprise that wants to buy machinery, equipment or any other fixed asset can get financial assistance from a leasing company. The leasing company is a business firm that supplies finance against the security of fixed assets. The fixed asset purchased under a leasing arrangement is mortgaged with the leasing company. The firm obtaining assistance has to repay the loan together with interest to the leasing company. Leasing is a popular source of finance in the purchase of vehicles. computers, equipment, plant. and buildings, ete. There are several leasing companies in our country that provide lease finance. Factoring (Accounts Receivable Financing) Factoring implies raising finance throuigh the sale or martgage of book debts. Finance companies or factors provide finance to business concerns through outright purchase of accounts receivable or against the security of accounts receivable. The finance companies generally make advances up to 60 per cent of the accounts receivable pledged with them. ‘The debtors of the firm make payments to it which, in turn, forwards them to the finance company. Sometimes, debtors may be required to make payments directly to the finance company. Bad debt losses, if any, are to be borne by the business concern itself. Outright sale of accounts receivable is known as ‘factoring’, The business concern is relieved of the cost and effort of collecting debts and bad debt losses. But it is an expensive method of financing. Customer Advances : In certain cases, manufacturers or suppliers of i advance before the delivery of goods, The customer advancoreneesn soe the goods ordered/booked by the customers to be suppli Whisaraineca t d hi , supplied at a later date. This arrangement is used in case of products which ich i ee produ are in short supply or which involve a waiting period for delivery, e.g., automobiles, telephone, etc. A nominal interest may be paid ea Sometimes, a business firm placing a big order/special order mar heen ne if it insista that goods are supplied well in time Th, Se aes a nauaite ; goods ¢ ; . The advance remains with the company until the product is delivered. At the time of delivery the adva; rarer i. f inert ce is adjusted in the price o 274 SBPD Pul Scanned with CamScanner