Essay on the Sources of Business Finance | Finance | Financial Management

After reading this essay you will learn about the long term and short term sources of business finance.

Essay on the Sources of Long Term Finance:

The sources of long-term finance include:

1. Issue of Equity and Preference Shares:

The share capital of a company is regarded as owned capital. A share is a unit of member’s interest in the company’s capital. The ‘equity share capital’ is the back bone of financial structure of any company.

The following are the features of equity shares:

i. Risk Capital:

They provide the so-called ‘risk’ or ‘venture’ capital of the company. Their prospects rise and fall with the prosperity of the company and with the state of business conditions in general.

ii. Fluctuating Dividend:

The equity shareholders are the real owners of the company. If it does badly, they may get no dividend at all, if it does well, they may get good dividends. If losses continue, the owners may be unable to recover even their original investment after meeting the loan obligations.

iii. Changing Market Value:

The market value of equity shares depends on the profit earned by the company. The market value is determined by buyers and sellers who take into account earnings, prospects, the quality and calibre of management and general business outlook.

iv. Growth Prospects:

The equity share of a company may also act as ‘growth share’ that is, with prospects for further growth in case the company over a period of time has very good scope for quick expansion.

v. Protection against Inflation:

Equity shares represent the best hedging or insurance device, fully protecting investors against rising prices and against diminishing purchasing power of the currency. Investments in fixed income securities are poor hedges in an inflationary period.

vi. Voting Right:

Equity shareholders enjoy a statutory right to vote in the general meeting and thus exercise their voice in the management and affairs of the company.

‘Preference Shares’ are so called because the holders of such shares have preferential rights over equity shareholders.

These shares have three distinct characteristics:

i. They have the right to claim dividend out of profits at the fixed rate. However, payment of dividend is not legally compulsory. At the time of declaration of dividend, preference shareholders have a priority over equity shareholders.

ii. Preference shareholders have also the preferential right of claiming repayment of capital in the event of winding up of the company.

iii. Preference shares do not enjoy normal voting rights and voice in the management of the company’s affairs except when their interests are being directly affected.

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

Preference shares may be issued as:

i. Cumulative or Non-Cumulative:

In case of cumulative preference shares, if dividend cannot be paid due to inadequate profits in a particular year the arrears of dividend will accumulate and become payable in subsequent years when profits are adequate. Others are non-cumulative preference shares.

ii. Participating or Non-Participating Shares:

If the shareholders, in addition to the fixed rate of dividend, are entitled to a further share in surplus after paying a reasonable dividend to equity shareholders, the shares are termed as participating, otherwise non-participating preference shares.

iii. Redeemable or Non-Redeemable Shares:

Redeemable shares are those which the company undertakes to repay after a certain specified period. Where such is not the case, the shares are called non-redeemable preference shares.

iv. Convertible Cumulative Preference Shares and Non-Cumulative Preference Shares:

A company may decide to issue cumulative preference shares with the additional provision that they will be convertible into equity shares, the preference shares are then known as convertible cumulative preference shares.

Merits and Demerits of Equity Shares:

The following are the advantages of equity share capital:

i. It provides risk capital.

ii. It is a source of permanent capital.

iii. It is the basis on which owners acquire their right of control over management.

iv. It does not require security of assets to be offered to raise ownership capital.

There are also certain limitations of ownership capital as a source of finance.

These are:

i. A company may find it difficult to raise additional ownership capital unless it has high profit-earning capacity, or growth prospects.

ii. Being a permanent source of capital, ownership funds cannot be reduced in the case of a company. A part of this fund may remain idle when there is no scope for expansion or fresh investment opportunities.

iii. Equity shareholders receive fluctuating dividends which may cause speculation and insider trading in these shares.

Merits and Demerits of Preference Shares:

Preference shares have the following merits:

i. It does not participate in the management of the affairs of the company.

ii. It helps to enlarge the sources of funds.

iii. Investors are inclined to invest in these shares due to the assurance of fixed return.

iv. Dividend is payable only when there are profits and the rate of preference dividend is fixed.

v. Trading on equity is possible.

The demerits of preference shares relate to some of its main characteristics:

i. They provided merely a fixed rate of return and that payment is also not legally compulsory. If it is not paid or accumulated as arrears, there is an adverse effect on the company’s credit.

ii. Investors seeking appreciation in value would not like to subscribe in preference shares.

iii. Dividend paid on preference shares is merely an appropriation of profits and not a charge, hence there is no tax-saving as in the case of interest payments.

2. Issue of Debentures:

It is a loan borrowed capital of the company. A debenture is the instrument of certificate issued by a company to acknowledge its debt.

Debentures have certain essential features:

i. They carry a fixed rate of interest.

ii. Generally they are repayable after a certain period as specified in the instrument itself.

iii. When debentures have to be retired, a huge amount is required. For this purpose a fund, known as ‘Sinking Fund’ is created so that the company does not find any difficulty in repaying the amount.

iv. Debentures may be converted into equity shares at the option of the debenture holders.

v. Usually debentures are secured over the immovable assets of the company.

Depending upon the terms and conditions of issue, there are different types of debentures:

(a) Secured or unsecured debentures;

(b) Convertible or non- convertible debentures.

The following are the merits of debentures:

i. It is a cheaper source of business finance since the rate of interest is lower than the rate of return on shares.

ii. Interest is a charge against profits of the company; so tax payable is reduced.

iii. Funds raised by the issue of debentures may be used in business to earn a much higher rate of return than the rate of interest (i.e., trading on equity is possible). As a result, the equity shareholders stand to gain.

iv. Issuing debentures during depression for raising finance is a convenient and easier source.

v. Debenture holders have no interference in the management of the company.

vi. Even financial institutions think it better to invest in debentures rather than to investment in shares of companies. This is due to the assurance of fixed return and repayment after a fixed period.

But it suffers from the following limitations also:

i. It involves a fixed financial commitment. The burden may be difficult to bear in case of falling profits.

ii. It is not possible to issue debentures beyond a certain limit due to the inadequacy of assets to be offered as security.

Shares and debentures can be made on the following grounds:

Distinction between:

a. Nature of Security:

A share indicates ownership while debentures indicate creditor ship.

b. Time of Issue:

Shares are issued by the company in the beginning to start a business while debentures are issued at a later stage to expend its business.

c. Return:

A Shareholder gets dividend when the company makes profit, and dividend may be fixed or fluctuating according to the nature of the share. A debenture holder gets interest at the fixed rate irrespective of profit or loss.

d. Repayment:

Equity shares can’t be purchased by a company. Redeemable preference shares are redeemable after the specified period. Amount of debenture is to be repaid usually at the end of a fixed period.

e. Rights and Privileges:

These are described in the Articles of Association whereas those of debenture-holders are defined in the debenture certificate.

f. Priority in Payment:

Priority in payment is available to debenture-holders at the time of winding up, but shareholders can get only if there is a surplus.

g. Debentures are profitable:

Debentures are profitable as under Income Tax Act., interest is a deductible item whereas dividend is an appropriation of profit, not a charge.

3. Loans from Financial Institutions:

A number of financial institutions have been set up by government with the main object of promoting industrial development. They play an important role as source of business finance.

Some of the important national level financial institutions are:

i. Industrial Credit and Investment Corporation of India (ICICI)

ii. Industrial Finance Corporation of India (IFICI)

iii. Industrial Development Bank of India (IDBI)

iv. Industrial Reconstruction Bank of India (IRBI)

v. National Industrial Development Corporation (NIDC)

vi. Unit Trust of India (UTI).

While financial institutions should play significant role in the financing of industry it is necessary to bear in mind very clearly that their contribution at best can be supplementary, marginal or subsidiary. Industries are expected to secure their capital requirements as far as possible directly through the open market approach. It is said that capital market institutions are not a resource of but a recourse to industrial finance, if open market approach is unable to satisfy their demands.

Apart from the national level institutions mentioned above, there are a number of similar Institutions set up in different states of India, viz.:

i. State Financial Corporations.

ii. State Industrial Development Corporations.

iii. State Industrial Investment Corporations.

The institutions operating in the capital market offer the following services:

i. Company Promotions.

ii. Company Underwriting.

iii. Company Finance.

iv. Institutional Investments:

Financial institutions at the national and state level provide long-and medium- term loans at reasonable rates of interest. They subscribe to the debenture issue of companies, and underwrite the public issue of shares and debentures. They also guarantee loans and deferred payments.

4. Retained Profits (Ploughing-Back of Profits):

Retained profit is an internal source of business finance. It is a part of the ownership capital of the company. Successful companies make use of retained profits as much as possible for expansion of their business.

Since profits belong to the shareholders, the amount of retained profit is treated as ownership fund which serves the purpose of medium-and long-term finance.

It is better than other sources of business finance due to the following reasons:

i. There is no fixed commitment on this source since it is a part of risk capital like equity share capital. Use of retained profit does not involve any cost to be incurred for raising the funds.

ii. It does not require the security of assets which can be used for raising additional funds in the form of loan.

iii. Control over the management of the company remains unaffected. As an internal source, it is more dependable than external sources. It is not necessary to consider investor’s preference.

Limitations:

Limitations of self-financing or ploughing-back of profits are due to excessive resort t to this practice of internal financing.

i. Tendency towards monopoly due to over-investment.

ii. Accumulation of resources often attract competition in the market.

iii. With increased earning shareholders expect a higher rate of dividend to be paid.

iv. Danger of over-capitalisation due to frequent issue of bonus shares.

v. Growth of companies through internal financing may attract government restrictions as it leads to concentration of economic power.

5. Public Deposits:

Strictly speaking, it is a banking function, but it is performed by non-banking companies also. This is an important source of medium-term finance which companies make use of.

The following are the advantages of such non-bank deposits:

i. Public deposits are not secured loans.

ii. It is a cheaper source of business finance.

iii. If a company has public confidence and it has able and sincere top management, it is very simple, convenient and easy source of business finance.

iv. It enjoys tax exemption.

v. It is very profitable instrument of ‘trading on equity’, particularly for established enterprises.

But, it is an unreliable source of finance. It is an uncertain source of company finance and it is difficult to formulate the financial plan on the basis of public deposits. It is also an unsound source of finance. With the development of banking facility, it is generally losing its old glamour and importance.

Essay on the Sources of Short-Term Finance:

Sources of short-term finance are:

1. Trade Credit:

Trade credit is a common source of short-term finance available to all companies. It is readily available and is a flexible source. It refers to the amount payable to the suppliers of raw materials, goods etc. after an agreed period, which is generally less than a year. It is to be noted here that it is a legal commitment and must be honoured in all cases Payment has to be made regularly.

The more important advantages of trade credit as a source of short-term finance are the following:

i. It is an economical source of business finance.

ii. Time of payment is generally adjusted according to the continuity of dealings.

iii. Trade credit is readily available.

iv. Trade credit is a flexible source of finance. It can be easily adjusted to the changing needs for purchases.

2. Bank Loans and Advances:

Commercial banks are essentially dealers in short-term credit to finance current assets or circulating capital. Merchant banking institutions offer variety of services like promotion, syndication of projects, investment advice, management advisory services, acceptance credit and discount services, etc. Bank loans and advances are available in the form of cash credit and overdraft. Commercial banks also provide short-term finance by discounting bills of exchange.

The rate of interest on bank credit is fairly high. But the burden is not excessive because it is used for short periods and is compensated by profitable use of the funds.

3. Short-Term Loans from Finance Companies:

Short-term funds may be available from finance companies on the security of assets. Some finance companies also provide funds through leasing. Many finance companies like HDFC, Kotak Mahindra, Ross Murarka Finance, CEAT Finance, Escorts Finance, ITC Classic, SRF Finance and many other established finance companies are doing nice job in this sphere.