SOURCES OF FUNDS

UNIT II
MEANING

 Sources of funds are the ways for mobilising various terms of finance to
the industrial concern. The companies, whether new or existing, requires
funds for their long term and short term requirements such as purchase of
fixed assets, construction of building, purchase of raw materials, payment
of wages etc.
CLASSIFICATION
EQUITY SHARES

 They are ordinary shares. It is the share in the ownership of the company. They have control over the management
of the company and are eligible for dividends. Its features are:
 No maturity period
 Right to get income left after the fixed dividend payment of preference shares
 Claim on assets after winding up of the company
 They have power to make decisions
 Equity shareholders liability is limited to the unpaid value of shares.
PREFERENCE SHARES

 Shares which have preferential rights to get dividends. They have fixed rate of
dividends but no voting rights. Preference shares are classified as:
i. Cumulative and Non-cumulative
ii. Redeemable and Irredeemable
iii. Participating and Non-participating
iv. Convertible and Non-Convertible
DEBENTURES

 Debenture is a certificate issued by the company under its seal acknowledging a debt.
It is a loan taken by the company. The debenture holder is entitled to a fixed rate of
interest on the debenture amount. Payment of interest on debenture is the first charge
against profit. The various types of debentures are:
i. Secured and Unsecured
ii. Redeemable and Irredeemable
iii. Convertible (Fully and Partly) and Non-convertible.
BONDS

 A bond, also known as a fixed-income security, is a debt instrument that represents a

loan made by an investor to the borrower. Bonds are usually issued by the
Government or by big corporates. When companies or other entities need to raise
money to finance new projects, maintain ongoing operations, or refinance existing
debts, they may issue bonds directly to investors. The borrower (issuer) issues a bond
that includes the terms of the loan, interest payments that will be made, and the time
at which the loaned funds (bond principal) must be paid back (maturity date). The
interest payment (the coupon) is part of the return that bondholders earn for loaning
their funds to the issuer. The interest rate that determines the payment is called
the coupon rate.
DIFFERENCE BETWEEN BONDS AND DEBENTURES

Bonds Debentures

A financial instrument showing the indebtedness of the A debt instrument used to raise long term finance
issuing body towards its holders

Generally secured by collateral It can be secured and unsecured

Low interest rates High interest rates

Issued by Govt. agencies, financial institutions, Issued by companies

corporations etc.
RETAINED EARNINGS

 Retained earnings are one of the methods of internal sources of finance. Actually is
not a method of raising finance, but it is called as accumulation of profits by a
company for its expansion and diversification activities. Retained earnings are called
under different names such as; self finance, inter finance, and ploughing back of
profits. According to the Companies Act 1956 certain percentage, as prescribed by the
central government (not exceeding 10%) of the net profits after tax of a financial year
have to be compulsorily transferred to reserve by a company before declaring
dividends for the year. Under the retained earnings sources of finance, a part of the
total profits is transferred to various reserves such as general reserve, replacement
fund, reserve for repairs and renewals, reserve funds and secrete reserves, etc.
INSTITUTIONAL BORROWINGS

 Institutional borrowing means finance raised from financial institutions other than
commercial banks. These financial institutions act as an intermediary or link between
savers and investors. They provide finance and financial services in areas which are
outside the purview of traditional commercial banking.
 Funds are raised from : Public Financial Institutions (PFIs), Non-Banking Finance
Companies (NBFCs) and Investment Trusts and Mutual Funds (ITMF).
 They provide both owned capital and loan capital for long and medium-term and
supplement the traditional financial agencies like commercial banks. Financial
institutions give technical assistance and managerial services to organisations. These
institutions give large funds for a longer duration.
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.
LEASE FINANCING

 Where there is a need for fixed assets, the asset need not be purchased. It can be taken
on lease or rent for specified number of years. The company who owns the asset is
called lesser and the company which takes the asset on lease is called lessee. The
agreement between the lesser and lessee is called a lease agreement. On the expiry of
the lease agreement, the owner takes the asset back into his custody. Under lease
agreement, ownership to the asset never passes. Only possession of the asset passes
from lesser to the lessee. Lease is not a loan. But when the business wants a certain
asset for a short/medium period, lease can significantly reduce the financial
requirements of the business to buy the asset.
HIRE PURCHASE

 It is a facility to buy a fixed asset while paying the price over a long period of time. In
other words, the possession of the asset can be taken by making a down payment of a
part of the price and the balance will be repaid with a fixed rate of interest in agreed
number of instalments. The buyer becomes the owner of the asset only on payment of
the last instalment. The seller is the owner of the asset till the last instalment is paid.
In case there is any default in payment, the seller can reserve the right of collecting
back the asset. It provides an opportunity to keep using the asset much before the full
price is paid.
DIFFERENCE BETWEEN LEASE AND HIRE PURCHASE
VENTURE CAPITAL

 Venture capital is normally provided in such projects where there is relatively a

higher degree of risk. For such projects, finance through the conventional sources
may not be available. Many banks offer such finance through their merchant banking
divisions, or specialist banks which offer advice and financial assistance. The
financial assistance may take the form of loans and venture capital. In the case of
viable or feasible projects, the merchant banks may participate in the equity also. In
return, they expect one or two (depending up on the volume of funds pumped in)
director positions on the board to exercise the control on the company matters. The
funds, so provided by the venture capital, can be used for acquiring another company
or launching a new product or financing expansion and growth.
SHORT TERM FINANCE

 The major sources of short term finance are:-

1) Commercial Paper (CP): Commercial paper is an unsecured, short-term debt instrument issued by a
corporation, typically for the financing of accounts payable and inventories and meeting short-term
liabilities. It is usually issued at a discount. It is issued in large denominations by nationally reputed
credit worthy companies.
2) Bank Overdraft: this is a special arrangement with the banker where the customer can withdraw more
than what is available in their account. Interest is charged on day-to-day basis.
3) Trade credit: This is short term credit facility extended by sellers. It is common for traders to buy
materials and other supplies on credit. Sometimes the suppliers may insist the buyer to sign a bill of
exchange. This is called bills payable.
4) Advance from Customers: it is customary to collect full or part of the order amount from the customer
in advance. This is usually done when the product is customised.
FACTORING

 Factoring is a financial service in which the business entity sells its bill receivables to
a third party at a discount in order to raise funds. When a business makes sale on
credit they receive the bill as a promise from the buyer that the payment of the bill
will be made on a later date. But if the seller is in immediate need for funds they go
for factoring.
 The intermediary agent that finances the receivables is called the factor. A factor
advances most of the invoiced amount to the company immediately and the balance
upon receipt of funds from the invoiced party.
TYPES OF FACTORING

1. Full Factoring: also called ‘without recourse factoring’. It is a facility offering all types of services namely
finance sales ledger administration, collecting, debt protection and customer information.
2. Recourse Factoring: this provides all types of facilities except debt protection. Under recourse factoring, the
client’s liability to factor is not discharged until the customer pays in full.
3. Maturity factoring: also called ‘collection factoring’. The payment is effected to the client at the end of
collection period or the day of collecting accounts whichever is earlier.
4. Advance Factoring: the factor provides advance at an agreed rate of interest to the client on uncollected and non-
due receivables.
5. Bulk Factoring: it is a modified version of involve discounting wherein notification of assignment of debts is
given to customers.
FACTORING PROCESS

1. Sells goods and

raises invoice.
Seller Buyer
6. Makes payment of
factoring fee.
3.Pays 75 to 5.Makes remaining 4. Makes invoice payment
80% of invoice payment
value
2. Sends invoice Factor
for funding
WORKING CAPITAL MANAGEMENT

 Working capital refers to the day-to-day expenses of a business. The business should maintain its
liquidity for the smooth functioning of its operations.
 There are 2 concepts of working capital:

a) Gross Working Capital: it is the total investment of a company in its current assets.
b) Net Working Capital: it is the excess of current assets over current liabilities.

Working capital management is a business strategy designed to ensure that a company operates efficiently
by monitoring and using its current assets and liabilities to the best effect.
DETERMINANTS OF WORKING CAPITAL

1. Nature of Business
2. Credit Policy
3. Growth Rate of the Business
4. Payables payment terms
5. Production Process
6. Business Cycle
7. Seasonality of the product
POLICIES OF FINANCING CURRENT ASSETS

1. Hedging or matching policy: it is the method of offsetting the finance for an asset with a liability
that matures on the expected life of the asset. Eg. If a machinery has a life of 5 years, the company
finances it with a loan of 5 years.
2. Conservative policy: when a firm depends more on long-term sources for its financing needs, it is
said to be a conservative one. If the firm has no temporary current assets at any period, it invests the
surplus funds into marketable securities. It is less risky.
3. Aggressive policy: under this policy the firm finances a part of its permanent current assets with short-
term financing. It relies more on short term than on long term sources of financing. It might be risky
since regular renewal is required.
CASH MANAGEMENT

 Cash management is the process of collecting and managing cash flows.

 Cash is the primary asset a company uses to pay their obligations on a
regular basis. Companies have a multitude of cash inflows and outflows
that must be prudently managed in order to meet payment obligations,
plan for the future payments, and maintain adequate business stability.
OBJECTIVES OF CASH MANAGEMENT

 Fulfil working capital requirement

 Planning capital expenditure
 Handling unorganised costs
 Initiates investment
 Better utilization of funds
 Avoiding insolvency
CASH MANAGEMENT MODELS

1. The Baumol’s EOQ model: William J. Baumol suggested that cash may be managed in the same way as inventory
and that the inventory model could reasonably reflect the cost – volume relationships as well as the cash flows. In
this way, the economic order quantity (EOQ) model of inventory management could be applied to cash
management. The Baumol model finds a correct balance by combining holding cost and transaction costs, so as to
minimize the total cost of holding cash.
Optimum level of Cash Balance

Where,
A – annual cash payment estimated
T – Cost per transaction
I – Interest on marketable securities.
EXAMPLE

 The outgoings of Gemini Ltd. are estimated to be Rs.5,00,000 per annum, spread
evenly throughout the year. The money on deposit earns 12% p.a. more than money in
a current account. The switching costs per transaction is Rs.150. Calculate the
optimum amount to be held.
2. MILLER-ORR CASH MANAGEMENT MODEL (STOCHASTIC
MODEL)

 The Miller-Orr model assumes that different amounts of cash payment are made at different point of time. As per
this model the companies let their cash balance move within the Upper Control Limit and Lower Control Limit.
FORMULA

Spread = 3 [ ¾* transaction cost x variance of cash flow ] ^1/3

interest rate

 Return Point = Lower Limit + (1/3 x Spread)

 Upper limit = Lower Limit + Spread
RECEIVABLES MANAGEMENT

 Receivables are the sales made on credit basis.

 Receivables management is the process of making decisions relating to
investment in trade debtors. Certain investment in receivables is
necessary to increase the sales and profits of the firm. But at the same
time investment in this asset involves cost consideration also.
COST INVOLVED IN RECEIVABLES MANAGEMENT

o Carrying Cost: cost incurred for arranging additional funds to support credit.
o Administrative Cost: cost incurred to maintain records and to collect the amount
from the customers. Eg. Salary of staff, cost of phone calls as reminders etc..
o Delinquency Costs: cost of additional steps taken to recover the amount due from
defaulting customers.
o Defaulting Costs: Sometimes the firm is unable to collect the due amount from its
customers. These debts are called bad debts and are written off.
OBJECTIVES

 Maximise return on investment in receivables

 Maximise sales by ensuring that the risk involved remains within the acceptable
limits.
 Maintain up-to-date records.
 Accurate billing
 Establish credit policies
COLLECTION METHODS

 Post-dated cheques
 Bank drafts
 Debt collector
 Bill of exchange
 Pay orders
 Collection through agents
 Lock-box system
 Factoring
 Concentration banking
INVENTORY MANAGEMENT

 Inventory is the physical resource that a firm holds with an intention to sell it or
transform it into a more valuable state. It includes raw materials, work-in-progress,
finished goods, tools and equipment and any other component that may form a part of
the finished goods.
 Inventory management refers to purchasing, storing and utilising the company’s
inventory.
NEED FOR INVENTORY MANAGEMENT

 A company’s inventory is one of its most important asset. The shortage of inventory
may lead to stoppage of production. But at the same time inventory can be thought of
as a liability. Large inventory carries the risk of spoilage, thrift, damage or shift in
demand. Thus inventory management is important for business of any size. Knowing
when to restock certain items, what amounts to purchase or produce, what price to
pay—as well as when to sell and at what price— are the major decisions to be taken.
METHODS OF INVENTORY MANAGEMENT

1. Economic Order Quantity (EOQ)

2. Just In Time (JIT)
3. Materials Requirement Planning (MRP)
4. Day Sales of Inventory (DSI)
FINANCING OF WORKING CAPITAL

 Sources of working capital can be spontaneous, short term and long term.
 Spontaneous working capital includes mainly trade credit such as the sundry
creditor, bills payable, and notes payable.
 Short term sources are tax provisions, dividend provisions, bank overdraft, cash
credit, trade deposits, public deposits, bills discounting, short-term loans, inter-
corporate loans, and commercial paper.
 Long-term sources are retained profits, share capital, long-term loans, and debentures.