ME4104 Principles of managements

Finance
Sources & Classification

PRESENTED BY
 KARAN KUMAR  R SARADA
 RAZA RAHEES  OLGA MOHAN
 HAANI  M. CHARITHA
 K. SAI MADAN  SAMEEKSHA
 MD. HASHIR  JIJI K
 Learning objectives
PART I
• Why a business may need finance?
• What are various sources of finances(SsOF)
• What are the advantages and disadvantages of d/f
sources of finance?
PART II
• D/f Types and classification of shares and debenture.
PART III
• About Ploughing Back of Profit.

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 PART I

Sources of finance

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 Brief Introduction

• Finance : It is used to purchase things or assets , what the

business needs or wants.
• Sources of finance : it is a method of getting hold of the
money you need.

Most of the time you need to pay it back and it can be

expensive.

Need of finance :
1. When it is starting-up
2. When it needs to by equipment or premises
3. When we want to expand our business
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 Necessity…
Business stands on 4M’s theory they are:
1. Money
2. Men
3. Machinery
4. Methods

 Money is the main parameter of the Business.

 So getting money into play is FINANCING.

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 Factors that determine SsOF

Amount
required
How
quickly
Purpose
Sources money is
needed

of
Length
of the
time-
Finance Cheapest
option
available
period
Amount
of Risk

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 Types & classifications of SsOF
Sources of finance

Source Ownership
of & Time Period
Generation Control

Owned Borrowed
Internal sources External sources Long term Medium term Short term
Capital Capital

Share capital
Trade credit
Equity capital Or equity share
Capital arranged Preference capital Working capital
Preference capital Preference
from outside Debentures/ Bonds loans from
Retained earnings sources capital commercial banks
Loans from:
Convertible Like: Retained earnings Financial institute Creditors
debenture
Financial institute Debenture/bonds Government, and Payable
Venture fund or commercial banks
Commercial banks Term Loans Factoring services
private equity
General public in Venture funding Lease finance Bill discounting
case of debenture Hire purchase Fixed deposits from
Foreign currency
loans e.g. ADR GDR customers
Asset securitization

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 Process of selecting right source
 SsOF are most explorable area especially for the
entrepreneurs who are about to start a new business.

 Having known that there are many alternatives of finance or

capital, it’s key challenge a very crucial decision for a
financial manager to choose right source.

 For example: Ordinary Shares, Preferential Shares, Loan

Stocks, Debentures, Retained Earnings, Government
Assistance, Bank Lending, Leasing, Hire Purchasing, Venture
Capital, Franchising, Angel Investment, Depreciation, Trade
Credit ,etc., are the examples.
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 Terms & Definition in financing
• Ordinary Shares: Company’s Shares Issued to the General
Public.
– Generally of Nominal Value
• Preferential Shares: It is the Main source of Finance to the
Company.
– Open only certain people. Like Shares are sold to people who’s
Income is above a certain value. These people will get fixed
dividends.
– Has priority over the Ordinary share holders.
• Loan stocks: Long term debt capital, raised by the company for
which interest is paid half yearly. A collateral is compulsory for
this kind of source.
• Debentures: It’s a type of a loan stock, but the
Acknowledgement of the debt that is incurred by the Company.
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 T & D in financing cntnu…
• Retained Funds: Part of the profit, that does not goes as a
dividend ,but goes as part of the Capital. Profit Reinvestment is
again Profit.
• Government Assistance: Government finances the companies in
form of cash grants, giving permission to build small scale
industries in Barren lands, to develop the National Economy and
to reduce the Unemployment.
• Bank Lending: Mainly short termed. Interest rate is based on
basis of day to day transactions. Normally term is 1 to 3 years
long. Can also be Middle termed, Based on the Credit standards,
Riskiness of the Borrower. Term is normally 3 to 10 years.
• Leasing: No transfer of Ownership. Agreement between two
parties. Lessor Owns the asset and Lessee pays according to the
terms for a certain period of time. For example Plant machinery,
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cars, vehicles, Office equipment, etc.
 T & D in financing cntnu…
• Hiring Purchase: Hire Purchase is a form of installation of credit.
Here there could be a transfer of Ownership is the purchaser
pays the last credit instalment.
• Venture Capital: Financing provided by Investors to startup the
companies that are believed to have long term growth.
• Franchising: A party allows other party to use its trademark to
produce certain goods under certain limitations and
specifications.
• Angel Investment: Investment by an affluent Individual who
provides capital for a business start up. Usually in exchange for
convertible debt or ownership equity.
• Depreciation: The monetary value of an asset decreases over
time due to use, wear, tear or obsolesce. This is a method to
allocating a value to tangible and intangible assets.
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 D/f Classification…
The Sources of the Finance are classified based on
1. Time Period
2. Source of generation
3. Ownership of control

On the basis of time period SsOF are :

– Long term sources of finance
– Middle term sources of finance
– Short term sources of finance

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 On the basis of Time Period …
LONG-TERM SOURCES OF FINANCE
– means Capital requirements.
– Generally for a period of more than 5 to 10,15 or 20 years or
maybe more depending on many factors.
– Capital expenditures in fixed assets like plant and machinery,
land, and building are funded with long term sources of finance.
– Part of the work capital which stays with the business is also
financed with long term sources of finance.
– The capital required for these assets is called fixed capital.
• required for modernization, expansion, diversification and
development of business operations.
• Funds required for this part of the working capital and for fixed
capital is called long term finance.
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Purposes could be any of the following:

– To purchase new asset or equipment

– To finance the permanent part of the working capital
– To enhance the cash flow in the firm
– To invest in R&D operations.
– To construct or build new construction projects
– To develop a new product
– To design marketing strategies or increase facilities
– To expand business operations

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 Factors determining long-term financial requirements :
The amount required to meet the long term capital needs of a
company depend upon many factors. These are :

(a) Nature of Business:

• The nature and character of a business determines the
amount of fixed capital.
• A manufacturing company requires land, building,
machines etc. So it has to invest a large amount of
capital for a long period.
• A trading concern dealing in, say, washing machines
will require a smaller amount of long term fund
because it does not have to buy building or machines.

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 (b) Nature of goods produced:
If a business is engaged in manufacturing small and simple
articles, it will require a smaller amount of fixed capital as
compared to one manufacturing heavy machines or heavy
consumer items like cars, refrigerators etc. which will
require more fixed capital.

(c) Technology used:

In heavy industries like steel the fixed capital investment is
larger than in the case of a business producing plastic jars
using simple technology or producing goods using labor
intensive technique.

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It can be internal or external :

The Internal Sources of long-term finance include :

• Retained Earnings
The External Sources of Long Term Finance include :

• Equity Capital
• Preference Capital
• Term Loan
• Debentures

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Retained Earnings:
Represent portion of the equity earnings sacrificed by the equity
shareholders and is ploughed back into the firm to reinvest these
in the core business operations
Equity Capital:
Refers to that portion of the organization’s capital, which is raised
in exchange for the share of ownership in the company.
Preference Capital:
– Portion of capital which is raised through the issue of the preference
shares.
– Hybrid form of financing that has certain characteristics of equity and
certain attributes of debentures.
Debentures: Debt instruments used to raise additional capital from
the general public.

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Term Loan:
Primary source of long-term debt raised by the companies to finance the
acquisition of fixed assets and working capital margin.
Advantage :
– Interest on debt is tax-deductible, whereas the equity or
preference dividends are paid out of profit after tax.
– The lenders are not entitled to the profits of the firm as they are
only paid the principal and the interest amount.

Disadvantege:
The firm is legally obliged to pay the fixed interest and principal
amount to the lenders, the failure of which could lead to its
bankruptcy.

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 On the basis of Time Period …
MEDIUM TERM SOURCES OF FINANCE:
 Generally financing over a period of 3 to 5 years.
 Used generally for two reasons i.e.,
 (I) when long-term capital is not available for the time being and
 (ii) when deferred revenue expenditures like advertisements are made
which are to be written off over a period of 3 to 5 years.
 This can also be anyone of the types below:
– Preference Capital or Preference Shares
– Debenture / Bonds
– Medium Term Loans from: Financial Institutes, Government, and
Commercial Banks
– Lease Finance
– Hire Purchase Finance

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Lease Finance:
 Lease financing is one of the important sources of medium-
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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Hire Purchase Finance
 A hire purchase is a method of buying goods through
making instalment payments over time. Under a hire
purchase contract, the buyer is leasing the goods and does
not obtain ownership until the full amount of the contract is
paid.
 To begin a hire purchase, a payment is often required up
front. The rest of the amount due is submitted through
scheduled payments
 Companies offering hire purchase options earn a profit by
applying additional costs to the monthly payment which
serves as interest charges for the purchase.

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 On the basis of Time Period …

SHORT TERM SOURCES OF FINANCE:

 In these days of tight Liquidity, organisations need short term
capital to support the cash flow in the company.
 Generally financing over a period of less than 1 year.
 Need for short-term finance arises to finance
The current assets of a business like an inventory of raw
material and finished goods, debtors, minimum cash and
bank balance etc.
Also named as ‘working capital financing’ .

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 Short term finances are available in the form of:
 Trade Credit
 Short Term Loans like Working Capital Loans from
Commercial Banks
 Fixed Deposits for a period of 1 year or less
 Advances received from customers
 Creditors
 Payables
 Factoring Services
 Bill Discounting etc.

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Trade Credit :
– An arrangement to buy goods or services on account, that is,
without making immediate cash payment .
– Trade credit is the credit extended to you by suppliers who let you
buy now and pay later.
– E.g. supplier offers 2% cash discount with 10 days and a net date of
30 days i.e. if you pay within 10 days, the purchase price will be
discounted by 2%, however if you chose to pay in the next 20 days
then you have to pay the full cost.

Working Capital Loans

– These are as good as term loan for a short period
– May be repaid in instalments or a lump sum at the end.
– The borrower should take such loans for financing permanent
working capital needs.

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Fixed Deposits for a period of one year
– A fixed deposit is a financial instrument provided by banks or
NBFCs which provide investors with a higher rate of interest
than a regular savings account until the given maturity date.
– The defining criteria for a fixed deposit is that the money
cannot be withdrawn from the FD before maturity.
– Some banks offer additional services to FD holders such as loans
against FD certificates at competitive interest rates.
– The tenure of the FD can vary from 7, 15 or 45 days to 1.5
years and can be as high as 10 years.

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 On the basis of ownership & control
On the basis of ownership and control SsOF divided into two
categories:
1. Owned Capital
2. Borrowed Capital

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OWNED CAPITAL:
o It refers to Equity capital.
o Sourced from the general public by issuing new Equity shares.
Following are the sources of the Equity Control:
o Ordinary shares, preference shares, Retained Earnings,
Debentures, Venture Fund. etc,..
o when the business grows and internal accruals like profits of the
company are not enough to satisfy financing requirements, the
promoters have a choice of selecting ownership capital or non-
ownership capital.

o Certain advantages are:

 It’s a long term capital which means stays permanently with
the business.
 No burden of interest and instalments like in the borrowed
capital.
 Low risk of bankruptcy.
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BORROWED CAPITAL:
o Capital arranged from the Outside sources.
o Examples like Financial Institutions, Commercial Banks, and General
Public in case of debentures.
o The borrower has a charge on the assets of the business which means
the company will pay the borrower by selling the assets in case of
liquidation.
o Another feature of borrowed capital is regular payment of fixed
interest and repayment of capital. There is no dilution in ownership
and control of business.

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 On the basis of source of generation
On the basis of source of generation SsOF are divided into two categories:
1. Internal Sources
2. External Sources

INTERNAL SOURCES:
 The Capital is generated Internally in the organization itself.
 In this type the Business grows by itself and does not depend on other
parties.
 Disadvantages of both Equity capital and debt capital are not present in
this form of financing.
 Neither ownership dilutes nor fixed obligation / bankruptcy risk arises.
EXTERNAL SOURCES:
 In External Source of finance generation, capital generated outside of the
business.
 Like by selling shares, debentures, leasing, hire purchasing etc.
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 PART II

Types & classification

Of
Shares and debentures
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 MEANING OF SHARES & SHARE
CAPITAL

 A share is one unit into which the total share capital is

divided. Share capital of the company can be explained as a
fund or sum with which a company is formed to carry on the
business and which is raised by the issue of shares.

 Shares are the marketable instruments issued by the

companies in order to raise the required capital.

 These are very popular investments which are traded every

day in the stock market and the value of the share at the end
of the day decides the value of the firm.
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 TYPES OF SHARES

• The shares issued by the company are two types :

1. EQUITY SHARES – Equity shares are issued and are traded in

everyday stock market. Their returns are not fixed.

2. PREFERENCE SHARES – Preference shares are market

instrument issued by the companies to raise the capital.

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 EQUITY SHARES

• Equity share holders only get dividend after preference share

holders & debenture holders.

• The returns of equity shares are not all fixed. It depends on

the amount of profits made by the company.

• The board of directors decides on how much of the dividends

will be given to equity share holders. Share holders can
accept to it or reject the offer during annual general meeting.

• Equity share holders have the right to vote on any resolution

placed before the company.
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 TYPES OF EQUITY SHARES

• The Equity share is a common name, some of the types of

equity shares-

a. Blue Chip shares.

b. Income shares.
c. Growth shares.
d. Cyclical shares.
e. Defensive shares.
f. Speculative shares.

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a) Blue Chip Shares: The big companies which have the potential to dictate
the terms come under this umbrella. These companies are never fixed as
performance of these companies may fall apart sometimes.
b) Income Shares: The companies coming in this area, are generally stable and
do not vary much in their performance
c) Growth Shares: These companies have secured their positions in specific
industry; their shares have less dividend payout ratio and thus, more
growth potential.
d) Cyclical Shares: The share of the companies coming into this umbrella
varies with the economy. A definite business cycle keeps on operating and
the performance keeps on operating with the stages of the cycle.
e) Defensive Shares: The shares of the company do not vary with the
economy.
f) Speculative Shares: The shares of a company which has usually more
speculation than others and they cannot be categorized into one category
only and may overlap with blue chip shares.

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Another type of classification of shares given by one of the most
successful investor Peter Lynch. According to him they can be
clarified into

– Slow growers.
– Fast growers.
– Stalwarts.
– Cyclical.
– Turn-Around.
– Asset plays.

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a) Slow growers: These are the companies having growth rate
equal to the industrial growth rate or higher than GDP.
b) Fast Growers: Newly started companies having good growth
rate.
Stalwarts: The big companies having and whose dividend
payout is high.
c) Cyclicals: The shares of these companies are not going
through the business cycle or varying to the business cycle.
d) Turn-around: The shares of those big companies whose
performance were very bad in the past but a sudden turn
around takes place and they started performing very good.
e) Asset Plays: These shares generally do not have recognition
instead of having a large asset base.

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 Advantages & Disadvantages
Advantages:
• High Return.
• Easily Transferable.
• These can be easily liquidated.
• Right to vote.
• Right to choose the board of directors.
• Equity share holders have the right to oppose any of the decisions
taken by the board of directors. (for e.g. This is what happened
when Mr. Ramalinga raju tried to buy Maytas company)
Disadvantages:
• High Risk.
• In worst cases less privilege given to equity share holders.
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 PREFERENCE SHARES

• These are other type of shares. The preference shares are

market instrument issued by the companies to raise the
capital.

• Preference shares have the characteristics of both equity

shares and debentures.

• Fixed rate of dividends are paid to the preference share

holder as in case of debentures, irrespective of profit earned
by company is liable to pay interest to preference share
holders.

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TYPES OF PREFERENCE SHARES

Preference shares are classified into:

– Cumulative and Non cumulative shares.

– Convertible and Non convertible shares.
– Participating and Non participating shares.
– Redeemable and Non redeemable shares.

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a) Cumulative and Non-cumulative Shares: Let us say that a
company was not doing well for 4 years but suddenly in the 5th
year it started performing well. Then, the persons having
cumulative shares will get the interest of past 5 years but the
persons having non-cumulative shares will get only the interest
of the 5th year.
b) Redeemable and Non-redeemable: Redeemable shares could be
matured during the lifetime of the company or before the
company closes down , they have a maturity period but the non-
redeemable shares mature only after closing down of the
company.
c) Convertible and Non-convertible: Shares that could be
converted into other kinds of shares and security say equity
shares or debentures is known as convertible shares and if they
are not convertible on their maturity they are known as non-
convertible shares.
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d. Participating and Non-participating: In case of winding up
of the company, the debenture holders were paid up first, then
the preference shareholders and then the equity shareholders
were paid up, after this if any surplus amount is left, it is
distributed equally to equity shareholders and participating
shareholders if investors have participating preference.

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 Advantages & Disadvantages

Advantages:
– These yield fixed rate of returns.
– It’s a hybrid instrument having some of the characteristics
of debentures and equity shares.

Disadvantages:
– They do not provide the investor with any of the voting
rights.
– If the company got huge profits then they wont get any
extra bonus.

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 DEBENTURES

• Debentures are also the capital market instruments which are

used to raise the medium and long term capital funds in the
public.

• These are the debt instruments which acknowledges a loan to

the company and is executed under the common seal of the
company and the deed shows the amount of loan and date of
repayment.

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 DEBENTURES

• Instrument of debt executed by the company.

• A certificate of loan.
• Company pays pre specified percentage of interest.
• Part of the company's capital structure.
• Debentures are generally secured against the company’s
assets.
• Convertible debentures can be either fully or partly
converted into shares.
• Convertible debentures may carry a lower rate of interest.

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 TYPES OF DEBENTURES

1. SECURITY POINT OF VIEW

– Secured debentures.
– Unsecured debentures.
2. MODE OF REDEMPTION POINT OF VIEW
– Redeemable debentures.
– Perpetual debentures.
3. CONVERTABILE POINT OF VIEW
– Convertible debentures.
– Non convertible debentures.

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4. PRIORITY POINT OF VIEW
– First Debenture
– Second debenture
5. RECORD POINT OF VIEW
– Registered debenture
– Unregistered debenture

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 1. On point of view of record:
a. Registered debentures: These debentures are registered with
the company and the amount is payable only to those
debentures holders whose names are registered with the
company.
b. Bearer debentures: These debentures are not registered with
the company, these are transferable merely by delivery and
the debenture holder will get the interest.
2. On the basis of security:
a. Secured or mortgaged debentures: These are secured by a
charge on the assets of a company. The principle amount and
the unpaid interest could be recovered by the holder out of the
assets mortgaged by the company.
b. Unsecured debentures: They do not get any security in
reference to principal amount or unpaid interest. They are
simple debentures.
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3. On the basis of Redemption:
a. Redeemable Debentures: They are issued for a fixed period
and the principle amount is paid off only at the expiry of
that period or at the maturity.
b. Non-redeemable debentures: They are matured only after
the liquidation or closing down or winding up of the
company.

4. On the basis of convertibility:

a. Convertible debentures: These can be converted to shares
after the expiry of the period i.e. on their maturity.
b. Non –Convertible debentures: These cannot be converted
to shares on their maturity.

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 5. On the basis of priority:
a. First debentures: These are redeemed before other
debentures.
b. Second debentures: These are redeemed after the
redemption of the first debenture

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 Advantages & Disadvantages

ADVANTAGES

• Control of company is not surrendered to debenture holders

because they do not have any voting rights.
• Interest on debenture is an allowable expenditure under
income tax act, hence incidence of tax on the company is
decreased.
• Debenture can be redeemed when company has surplus
funds.

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DISADVANTAGES

• Cost of raising capital through debentures is high of high

stamps duty.

• Common people cannot buy debenture as they are of high

denominations.

• They are not meant for companies earning greater than the
rate of interest which they are paying on the debentures.

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 PART III

Ploughing back of profit

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 PLOUGHING BACK OF PROFIT
• A technique of financial management under which all
profit of the company is not distributed to the
shareholders as dividend, but a part is retained or re-
invested in the company.
• Thus over years the profit builds up and can be utilised in
the business.
• It is also called Self-financing, Internal financing or
Inter-financing.
• It is an ideal source of financing expansion and
modernisation schemes as there is no immediate pressure
to pay a return on this portion of stockholders’ equity.
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• A part of total profits is transferred to various reserves
such as General Reserve, Replacement Fund, Reserve
Fund, Reserve for Repairs and Renewals, etc.
• Sometimes ‘secret reserves’ are also created without
the knowledge of the shareholders.
• From all the practices of financial management, this
system of ploughing back of profits is considered
desirable as it helps in the financial and economic
stabilisation of the concern.

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 Necessity…
 For the replacement of old assets which have
become obsolete.
 For the expansion and growth of the business.
 For contributing towards the fixed as well as the
working capital needs of the company.
 For improving the efficiency of the plant and
equipment.
 For making the company self-dependent of
finance from outside sources.
 For redemption of loans and debentures.
 Factors effecting

 Earning Capacity
 Desire and Type of Shareholders
 Future Financial Requirement
 Dividend Policy
 Taxation Policy
• Earning Capacity:
Ploughing-back of profits depends largely upon the earning
capacity of the company. If a concern does not earn
sufficiently, there is no possibility of ploughing-back of
profits. Usually, greater is the earning capacity of a company,
larger is the possibility of ploughing-back of profits.

• Desire and Type of Shareholders:

The policy of ploughing back of profits is also affected by the
desire and type of its shareholders. If shareholders largely belong
to the class of retired persons, widows and other economically
weaker persons, they may desire maximum distribution of profits
as dividend. On the other hand, a wealthy investor may not mind
if the company retains a portion of profits for future
development.
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• Dividend Policy:
The re-investment of profits depends to a great extent upon the
dividend policy of the company. If a company desires to plough
back profits it cannot follow a policy of a very high dividend
payout.
• Taxation Policy:
The taxation policy of the Government also affects the re-
investment of profits. A high or low rate of business taxation
affects the net earnings of the company and thereby its re-
investment policy.
• Future Financial Requirement:
Future financial requirements of the company also affect the
policy of ploughing back of profits. If a company has highly
profitable investment opportunities for future development, it
may plough back its profits more successfully.
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 Thank you All
for
Your time
&
Patience
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