Sources of Finance - Based on Repayment Periods
Sources of Finance
A Company may raise finance from many sources. Based on
repayment period these sources are broadly classified into two categories:
Long Term
Sources
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Short Term Sources
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Long Term Sources:
Sources through which funds are raised for long term use
in the business are termed as long sources. These are explained as below:
Shares: Funds raised from
Issue of shares constitute the Ownership Fund of the company. Those who invest
in shares are known as shareholders. A public company can issue two types
of shares:
1. Equity
Shares
2. Preference
Shares
1. Equity Shares
They are the real owners of the company. Full
voting rights are guaranteed to equity shareholders. They participate in the
meetings of the shareholders, elect directors and approve major changes in the
policies and programs of the company. Equity shares are listed at the stock
exchange and are freely transferable.
The rate of dividend is not fixed. It is decided by the
board of directors on the basis of profits left after making payments of
preference shares dividend. Therefore, the investors bear the maximum risk but
may enjoy the maximum profits if the company’s performance is good.
Features of Equity Shares are as follows:
1. Capital
Appreciation: Equity shares are listed at the stock
exchange and there is possibility of capital appreciation in the prices of
shareholders. They can also sell the shares, in case they want to
leave the company.
2. Dividend: The
rate of dividend is not fixed. It is decided in based on the profits available.
In case the company does not earn profit, no dividend is paid on equity shares.
3. Risk
Bearing: Equity Shareholders bear the maximum risk in the
company as they get dividend at the last. The investment is only returned only
on winding up of the company and that too after paying all other liabilities.
4. Voting
Rights: Equity shareholders have voting rights. All
important decisions are taken in the general meeting and extraordinary meetings
of a company, in which only equity shareholders have right to attend.
Advantages of Equity Shares
A.) From the company point of view
1. Large
funds – Equity shares have a small nominal value (say Rs.10
per share). It encourages the investors to invest in equity shares. There is no
limit of number of members in a public company. Therefore, a large number of
persons invest in equity shares and the company will be in a position to
collect huge amount of money through equity shares.
2. No burden
on profits – It is not obligatory on the part of the company to
pay dividend on equity shares in case the profits are not sufficient or the
company decides to retain profits for expansion or modernization.
3. No charge
on assets – A company is not required to mortgage or create a
charge on the assets of the company for raising funds through issue of equity
shares.
4. Permanent
capital – The funds raised through issue of equity shares
is permanent capital for the company. It is not required to be refunded during
the lifetime of the company. This amount is mostly used to generate fixed
assets of the company.
5. Source of
strength – Equity share capital reflects the strength of the
company because it is used for fixed assets and does not create burden for its
repayment or payment of dividend on regular basis.
B.) From the shareholder point of view
1. Bonus
shares and Right shares – Bonus shares and Right shares
are issued only to the equity shareholders.
2. Capital
appreciation – Equity shares are listed at the stock exchange and
the prices of shares go up in case the performance of the company has been good
and the market conditions are also favourable.
3. Higher
dividend – The rate of dividend on equity shares is not fixed.
It depends upon profits, in case the earnings of the company are good, the
directors recommend high rate of dividend.
4. Higher
Liquidity: Equity shares are traded at the stock
exchanges. So, it provides higher liquidity to investors. They can
sell the shares whenever, they are in need of money.
5. Voting
rights – Equity shareholders have full voting rights and
participate in the meetings of shareholders. They elect directors and approve
major policy changes.
Disadvantages of Equity Shares
A.) From the company point of view
1. Costly – The
cost of raising funds through issue of equity shares is high. A lot of money is
spend on underwriting commission, brokerage and other expenses.
2. Manipulation
of control – The management of the company may be manipulated by
few shareholders to maintain the control of the company in their own hands.
Sometimes, they may not work in the interest of the company.
3. No benefit
of trading on equity – If all the funds are
raised through equity shares, the company will not be able to take advantage of
trading on equity.
4. Overcapitalisation
– The funds raised through equity shares are not
returned during the lifetime of the company. Sometimes, more capital is raised
than required which results in overcapitalisation. It reduces earnings per
share.
B.) From the shareholders point of view
1. Concentration
of power in few hands – Some shareholders keep the control of the company
in their own hands by holding majority shares. Therefore, small investors may
remain at the mercy of such shareholders.
2. High risk –
Equity shareholders bear the maximum risk. They are the last to get return on
their investment, i.e., dividend and the capital when the company is closed.
3. Uncertainty
of dividend – Dividend on equity shares is paid only out of
profits. In case, the profits are not sufficient, no dividend is paid.
4. Unhealthy
speculation – The stock market fluctuates wildly because of
speculations by few operators. The management of the company may also indulge
into such activities which causes extensive loss to the innocent investors.
2. Preference Shares
These are those types of shares on which a fixed rate of
dividend is paid, and
1. Dividend on
preference shares is paid in priority to equity shares dividend, i.e., the
preference dividend is paid before dividend is paid on equity shares.
2. Return of
Capital: Preference share capital is paid back (returned) in
priority to equity share capital in the event of or at the time of winding up
(closing of) of the company.
Features/characteristics of Preference
Shares
1. A company
can issue different kinds of preference shares, like redeemable,
non-redeemable, cumulative or non-cumulative shares, etc.
2. A fixed
rate of dividend is paid on preference shares.
3. Preference
shareholders do not have voting rights and cannot take part in the meetings of
the shareholders.
4. The
preference share capital is returned in priority to equity share capital, if
the company is closed.
5. The
preference shareholders have preference in getting the dividend. It is paid in
priority to equity share dividend.
Types of Preference shares
1. Cumulative
preference shares – These preference shares have a right to get
dividend out of the profits and in case the profits are insufficient, the
dividend is to be carried forward and paid out of the future profits.
Non-cumulative preference shares –
Dividend on such shares is paid only out of the current year’s profit and in
case the profits are not sufficient, no dividend is to be paid and the
preference shareholders do not have the right to get the ‘arrears’ (past unpaid
amount) of dividend in the future.
2. Redeemable
preference shares – Such shares are redeemed (paid back) after a
fixed period of time and the preference share capital is returned to the
shareholders.
Irredeemable preference shares –
The amount raised from such shares is not redeemed during the lifetime of the
company and is to be paid back only after the winding up of the company.
3. Convertible
preference shares – Those preference shares which are given the right
or option to get their shares converted into equity shares after a fixed period
of time, are known as convertible preference shares.
Non-convertible preference shares –
Those preference shares which are not convertible into equity shares, are known
as non-convertible preference shares.
4. Participating
preference shares – These are those preference shares on which the
investors have the right to participate in the surplus profits left after
paying all dividends (i.e., preference share dividend as well as dividend on
equity shares).
Non-participating preference shares – Only
a fixed rate of dividend is paid on these shares and there is no right to
participate in the surplus profits.
Advantages of preference shares
A.) From the point of view of the company
1. Appeal to
cautious investors – A company is able to raise funds from those
investors, who want more security and stability or regularity in their earnings
as compared to equity shares.
2. Flexibility – A
company can maintain flexibility in its capital structure by issuing redeemable
preference shares.
3. No burden
on profits – There is no obligation on the company
to pay dividend in case of insufficient profits or when there are losses in the
company.
4. No charge
on assets – A company is not required to create a
charge on the assets of the company. Therefore, the assets can be used for
raising loans in the future.
5. No
interference in management – Preference shareholders do not
have voting rights, therefore, the shareholders are not allowed to interfere in
the management and decisions of the company.
6. Trading on
equity – The rate of dividend payable on preference shares
is fixed. When the earnings of the company are good, a higher rate of dividend
can be paid on equity shares.
B.) From
the point of view of the investors (Preference shareholders)
1. Cumulative
Dividend – In case of cumulative preference shares, the
dividend is carried forward and the arrears are paid out of the future profits.
2. Less risk –
Preference shares are less risky as compared to equity shares because there is
no fluctuation in the prices of shares and there is better security to their
investment as compared to equity shares.
3. Redemption –
Most of the preference shares are redeemable after a fixed period of time.
Therefore, the investors can get back their investment from the company.
4. Stable and
regular dividend – There is a higher possibility of getting stable
and regular dividend because preference dividend is paid before the equity
share dividend.
Disadvantages of Preference Share
A.) From the point of view of the company
1. Costly –
The dividend on preference shares cannot be treated as business expense,
therefore, the company has to pay higher rate of tax.
2. Low appeal –
Preference shares have a very low appeal to the investors. A cautious investor
prefers debentures than preference shares.
3. More legal
formalities – A company has to follow a number of legal
formalities when preference shares are to be redeemed
4. Permanent
burden – There is a permanent burden on the company to pay
dividend on cumulative preference shares
B.) From the point of view of the investors
1. Fear of
being shown the door – Preference shares are redeemable.
A company has the option to pay back the preference share capital in case it
has surplus funds.
2. No capital
appreciation – Preference shares are not listed at the stock
exchange, therefore, there is no possibility of increase of capital
appreciation of preference shares.
3. No
guarantee of dividend – Dividend on preference shares is
paid only out of profits. In case a company continues to suffer losses, no
dividend will be paid even on preference shares.
4. No voting
rights – Preference shareholders cannot
participate in the meetings of the shareholders.
3. Debentures:
MEANING:- Debentures
represent borrowed fund and is a loan capital. Debenture holders are
the creditors of the company.
Debenture is a document or a certificate issued
by the company as an acknowledgement of debt.
Interest on
debentures is paid at a fixed rate. Debentures carry no
voting rights but they generally involve a charge on the assets of the company.
CHARACTERISTICS:-
1. A fixed
rate of interest is paid on debentures.
2. Debentures
are generally redeemable and repayable after a fixed period of time.
3. Debentures
generally carry no voting rights.
4. Debentures
generally involve a charge on the assets of the company.
5. Debentures
represent borrowed fund.
6. Interest
is payable every year irrespective whether there are profits or not.
KINDS OF DEBENTURES:- Debentures
are of the following types:-
1. Bearer
Debentures:- These are those debentures which are transferable
by mere delivery. It is not necessary to inform the company about the
transfer. Interest is paid on the production of coupons attached to such
debentures. No register is maintained for bearer debentures.
2. Convertible
debentures:- In case an option is given
to the debenture holders to convert their debentures into equity shares after
the lapse of a specified period, these are called convertible debentures. It
provides a privilege to the investors to change their status from creditors to
the owners.
3. Non-convertible
debentures: All
debentures are non-convertible unless there is an option of conversion into
equity shares.
4. Redeemable
debentures:- These are those debentures
which are redeemed (paid back) after a fixed period of time. The time of
redemption is fixed at the time of issue. All debentures are redeemable unless
otherwise specified.
5. Irredeemable
debentures:- These are those debentures
which are not redeemed during the lifetime of the company. It is part of the
permanent capital of the company. Such debt becomes due for payment only when
the company goes into liquidation.
6. Registered
debentures: - Registered
debentures are those which are recorded in the Register of Debenture-holders
maintained by the company with full details as to number, value and type of
debentures held by each debenture-holder. Registered debentures cannot be
transferred by mere delivery. Such debentures can be transferred only by
transfer deed or intimation to the company. The transfer of such debentures is
recorded in the register of the company. A new debenture certificate is issued
to the buyer and name of seller of debentures is cancelled. The payment of
interest and repayment of debenture money is made to those debenture-holders
whose names are registered with the company.
7. Secured or
Mortgaged debentures:- Debentures which are secured
by a charge on the assets of the company, are known as secured debentures. In
case the company fails to the loan amount or the interest on time, these
debenture-holders have the right to recover their principal amounts, as well as
the unpaid interest, out of assets mortgaged by the company. The charge on
assets are of two types, Fixed Charge - When the charge is
given on some specific assets, it is known as fixed charge. And Floating
Charge - When the assets in general are give by way of security, it is
known as a floating charge.
8. Unsecured/naked/simple
debentures:- Such
debentures are unsecured and do not create any charge on the assets of the
company. In case of default in the payment of interest or the principal amount,
the debenture-holders can only file a case for the recovery of money and they
will be ranked along with other unsecured creditors of the company.
ADVANTAGES OF ISSUING DEBENTURES
A) Advantages from the point of view of
Company:-
a. Economical
source: The cost of raising funds through
debentures is relatively lower. This is because it is a safer investment and
the investors are ready to invest in debentures. The rate of interest on
debentures is also lower than the interest charged by banks on loans.
Underwriting commission, brokerage and other expenses of issue are lesser.
2. No
Interference in management: Debentures
do not carry voting right. Therefore, they cannot interfere in management. The
existing shareholders can continue control of the company.
3. Trading on
equity: Interest on debentures is
paid at a fixed rate. In case the earnings of the company increase, the rate of
dividend on equity shares can be increased. The policy of raising a
fixed income security with an objective of increasing dividend on shares is
called trading on equity.
4. Flexibility: A company
can repay the funds raised through debentures when it does not require the
funds any more. This facility of redemption avoids danger of
over-Capitalisation. It keeps the financial structure flexible.
5. Tax relief: Interest
on debentures is allowed to be treated as a business expense. Hence, it reduces
the net profit on which tax is to be imposed. It results in saving in income
tax liability.
B) Advantages
from the point of view of debenture-holders:
1. Fixed and
regular return: The
debenture-holders and paid a fixed rate of return at regular interval
irrespective of profits.
2. Security
of investment: Debentures
are usually secured by a charge on the assets of the company. This ensures
safety of investment in debentures, as their repayment is assured.
3. Appeal to
cautious investors: Debentures
is a good option for those investors who are cautious an orthodox. Safety of
investment and fixed rate of return attract such investors.
4. Stable
Prices: Prices of
investment in debentures is always fixed and stable. Debentures are not
speculated as shares.
DISADVANTAGES of Debentures –
A) From
the company point of view:
i) Permanent
burden of interest: A company
has to pay interest on debentures irrespective of the financial condition or
profits of the company. It becomes a heavy burden during depression and bad
days for the company.
ii) Charge
on assets: the assets
of the company are usually mortgaged with debenture-holders as a security. This
lowers the ability of the company to raise funds from banks and financial
institutions.
iii)Reduction in dividend: In case
the financial structure of the company is heavily loaded with debentures, a
large part of the earnings of the company will be paid in the form of interest
on debentures. In case of low earnings, very little profit might be left for
the shareholders. The market value of its shares may go down.
B) Disadvantages from the point of view of
Debenture-holders:-
i) No
voting rights: Debenture-holders
have no voting rights and cannot take part in management. Therefore they remain
at the mercy of shareholders.
ii) High
unit price: The price
per debenture is much higher as compared to shares. Therefore, small investors
may not be able to purchase debentures.
iii) Unattractive: Debentures
do not appeal much to the adventurous investors who want a high return and appreciation
of capital.
Difference between Shares and
Debentures:
S.No.
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Basis of difference
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Shares
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Debentures
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1.
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Status of holders.
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Share-holders are the owners of the company.
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Debenture-holders are the creditors.
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2
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Yield( reward for investment)
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Dividend is paid on shares only when the company earns
profits.
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Debenture-holders are paid interest irrespective of
profits.
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3.
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Nature of return
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Rate of Dividend fluctuates with profits on equity shares
but is fixed on preference shares.
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Rate if interest is fixed and regular on debentures.
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4.
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Security
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No security. Shares are issued without any charge or
mortgage on assets.
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Secured. Debentures are normally against the security
of certain assets.
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5.
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Voting rights
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Equity shares carry voting rights and participate in
the management of the company.
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Debenture holders do not have any voting
rights.
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6.
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Redemption
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Not redeemable except redeemable preference shares.
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Redeemable after a certain period.
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7.
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Order of repayment on winding up.
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The share capital is repaid in the last.
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Debenture money is paid in priority to equity shares.
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8.
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Convertibility
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Shares can not be converted into debentures.
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Convertible debentures can be converted into
shares
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9.
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Tax benefit
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Dividend on shares in not an expense and does not
reduce tax liability of the company
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Interest is an expense, reduce profits and the
tax liability.
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4. Ploughing back of Profits (Retained
Profits)
Meaning. That
portion of profits which is not distributed but is retained and reinvested in
the business is known as retained profits. The retained profits are
an internal source of finance. This method is also known as
reinvestment of profits or Ploughin back of profits or self-financing or
internal financing.
Under
this method of financing, a certain proportion of profits is transferred to
reserves which are shown under the heading ‘Reserves and surplus’
Since
retained earnings actually belong to the shareholders of the company, these are
treated as part of shareholders funds.
Use-The
retained earnings may be used to meet long-term, medium-term and short-term
financial needs of the company. Therefore retained earnings can be used by the
company for the following purposes (Need) :-
1. For the
replacement of old assets which have become obsolete.
2. For the
expansion and growth of the business.
3. For
contributing towards the fixed as well as working capital of the company.
4. For making
the company self-dependent for finances.
5. For
redemption of loans and debentures.
Main Features of retained earnings are as follows:
1. Undistributed
Profits: Retained earnings are profits which are undistributed for
kept in the company for the purpose of expansion or internal use.
2. Internal
Source of Finance : Retained earnings are an internal source
of finance.
3. Part of
Owner’s Fund: Retained Earnings are part of Owner’s Fund. It is shown
under the head Shareholders Funds along with share capital in the Balance
Sheet.
Merits:-
Advantages from the point of Company:
1. A Cushion
to absorb the shock of economy. A
policy of Ploughing back of profits acts as a cushion to absorb the shocks of
economy and business such as depression, trade cycles and uncertainty of the
market with comfort, preparedness.
2. Economical
method of financing: - It is economical
because the company does not have to pay any interest or return the funds. It
does not have to depend upon outsiders for raising funds required for
expansion, or growth.
3. Helps in
following stable dividend policy:- Ploughing
back of profits enables a company to follow stable dividend policy. Stability
of dividend means payment of dividend regularly and a company which ploughs
back its profits can easily pay stable dividends even in the years when there
are insufficient profits.
4. Makes the
company self- dependent: - A
company which plough back its profits does not have to depend upon outsiders
such as banks, financial institutions, debentures etc for additional funds.
5. No
Dilution of control:- A company
having sufficient reserves of profits need not issue fresh shares and the
present shareholders will be in a position to retain the control of the company
in their own hands. Thus the control of the existing shareholders will not be
diluted
6. Improve
Public Image: A company which has accumulated reserves and
surplus is viewed as a good company. Increased public image helps a company to
raise funds, whenever it needs.
Advantages from the point of Company:
1. Safety of
investment: Retained earnings increase financial strength of the company. This
will provide safety of funds to the shareholders.
2. Stable
Dividend : Retained earnings may be used for paying dividend in those years in
which a company may fail to earn good profit. Thus, shareholders may get
regular dividend.
3. Issue of
Bonus Shares: Retained earnings may be used to issue bonus shares. These are
allotted free of cost to the shareholders.
4. Appreciation
in the value of shares:- Retained
earnings reflect financial strength of the company. It is viewed very
positively by the investors community. As a result, the prices of shares may
rise in the long run.
7. Enables to
redeem long term liabilities:- It
enables the company to redeem certain long-term liabilities such as debentures
and thus relieves the company from the burden of fixed interest
commitments(burden)
Demerits: -
A ) From the point of Company:
1. Over-Capitalisation: - It means
more capital than actually required. Excessive Ploughing back of
profits may lead to Over-Capitalisation. This may lower the rate of return on
the capital employed.
2. Concentration
of Economic Power: Companies, which retain earnings
may indulge in acquire other companies through the stock market and grow
disproportionately.
3. Creation
of Monopolies:- Continuous re-investment of earnings
may lead a company to grow into monopoly with all its evils. The company may
expand to such limits that it may control the major part of the market, which
may not be in the interest of the public at large.
4. Misuse of
retained earnings:- Management may not utilize the
retained earnings to the advantage of shareholders at large as they have the
tendency to misuse the retained earnings by investing them in unprofitable
areas.
B) From the
point of Shareholders:
1. Depriving
the investors of higher dividends:- The
policy of Ploughing back of profits reduces the amount of dividends payable to
shareholders and this may frustrate the shareholders as they are deprived of
higher dividend.
2. Manipulation
in the value of shares:- The
management of the company(directors) may indulge in wrong practices. When
profits are retained, the rate of dividend reduces, which may lower the value
of shares in the market. They purchase the shares in the market at that time
and in the subsequent years when higher dividends are declared, such shares are
sold at higher prices and earn profits at the cost of ordinary shareholders.
The following topics are to be done from the Book
1. Loans from
Banks and Financial Institutions:
2. Bonus
Shares
3. Right
Shares
4. Employees
Stock Option Scheme
5. Sweat
Equity Shares
Sources of Short term Finance
1. Public Deposits:
· It refers
to the deposits accepted from the public on which a fixed rate of
interest is paid. The rate of interest is higher than rate of interest
paid by banks on their deposits.
· Only
Public Companies and non-banking companies are allowed to accept
public deposits. A private company is not allowed to accept deposits.
· The time
period of such deposits may range from 6 months to 3 years.
· Such
deposits are unsecured and no assets are required to be pledged.
Advantages :
1. No legal
formalities : It is a simple method, where public make deposits at
their free will. It involves no legal formalities which are required in the
issue of shares and debentures.
2. No charge
on assets : Public deposits
do not involve any charge on the assets of the company. The company can use its
fixed assets for raising funds from other sources.
3. No
interference in management: Depositors
do not have any voting rights. They can not take part in management and do not
interfere in the matters of the company.
4. Flexibility
in capital structure: The capital structure of the company can be kept
flexible by this method of finance. Fixed deposits can be returned if the
company is overcapitalized. On the other hand, additional finance can be raised
without much difficulty, in case of need.
5. Economical
: It is economical because the rate of interest
allowed on deposits is usually less than the interest rate charged by banks and
other financial intuitions on loans.
6. Trading on
equity: Interest on Deposits is paid at a fixed rate.
In case the earnings of the company good, the rate of dividend on equity shares
can be increased.
DISADVANTAGES:-
1. Unsuitable
for new concerns: This method is not suitable for new
companies as the public may be hesitant to invest for fear of loss of money.
2. Uncertainty
of getting deposits: Public deposits are called “fair weather
friends”. There is no certainty of getting a good response from public
particularly in period of depression.
3. Unsecured: Depositors
face high risk as public deposits are secured on the assets of the company.
4. Restrict
growth of capital market: Public
deposit hamper the grown the healthy capital market in the country. Widespread
use such a source may create shortage of industrial security. It may also pose
a threat to the credit planning and plan priorities of the Govt.
5. Possibility
of cheating( speculations): It is possible
that a company may project a good picture to attract public deposits. The funds
procured may be misused and thereby innocent investors may be cheated.
6. Loss of
creditworthiness: If
the deposit money is not paid on maturity on account of shortage of liquid
resources, the goodwill of the company may be adversely affected.
2. Commercial Banks:
Lending is an important function of commercial banks.
Banks provide finance to business enterprises in the following ways:
1. Loans and
Advances: the key features are as follows:
· It
is lump sum money advanced by way loan to the borrower for
which a bank opens a separate account in the name of the borrower in which the
amount is credited.
· Interest :
the borrower is required to pay interest on the whole amount from the date the
loan was sanctioned.
· Repayment: The loan
may be repaid either in installments at regular interval or in one time at the
expiry of a fixed term of loan.
· Withdrawal: the
borrower can withdraw the whole of the amount or a part of it but interest is
charged on the whole amount of loan.
· Security: The
loan may be secured or unsecured. However in most cases the banks ask for
sufficient security from the borrower before sanctioning the loan.
2. Cash
Credit: Its key features are as follows:
· Cash
credit is a kind of agreement with the bank under which a bank fixes a maximum
limit up to which the borrower can withdraw money. It is a running
account from which the amount can be withdrawn and paid back as per the needs of
the customer.
· The limit
is usually fixed based on the reputation and security offered
by the borrower.
· Interest is charged
only on the actual amount withdrawn.
The main advantage is flexibility in the
use of money and the convenience. The customer does not have to approach the
bank again and again in case of need of funds.
The disadvantage is the high rate of interest.
The disadvantage is the high rate of interest.
3. Bank
Overdraft: Main points are:
· Overdraft
is facility of withdrawing/making payment more than the balance in the bank.
· Overdraft
facility is granted to customers having a current account with
the bank.
· A maximum
limit of overdraft is fixed based on the reputation ( credit
worthiness) of the customer and the security offered by him.
· Interest is
charged on the actual amount of overdraft.
This is a very convenient and
flexible one time form of short term financial arrangement with the bank and
the customer does not have to ask bank if the payment exceeds the balance in
the bank.
4. Discounting
of Bills: Main points are:
· Discounting
of bills means getting cash from a bank in exchange of Bills of exchange
,promissory note etc.
· Bank
charge some commission/interest for this service by paying amount lower than
the face value of the bill. The charges are for the unexpired time period of
the bill. These are called discounting charges.
· On
maturity date of the bills, the bank will collect full amount of the bill from
the drawee ( debtor).
· The
borrower/customer remains liable to the bank, if the drawee fails to honor the
bill on its due date.
Advantages of funds from Commercial Banks:
Bank Credit has several
advantages:
1. Flexible: Bank
credit is highly flexible. There are many options for raising short term funds.
The money can be repaid whenever desired.
2. No
interference in management: Commercial banks do not interfere in
the working of the company. Only financial statements are to be submitted at
the specified time.
3. Easy
repayment option : In all the lending options, the banks provides
easy repayment option to the borrower, which is not available in any other
forms of borrowing.
4. Economical: short
term funds from banks prove to cheaper. This reduces interest burden on the
borrower.
Disadvantages:
1. Legal
formalities:
2. Shorter
period of funds: Funds from commercial banks are mostly for shorter
periods.
3. Charge on
assets: Banks generally require a charge on the assets of
company before funds are sanctioned.
4. High rate
of interest: The rate of interest charged by the banks is higher
than interest on debentures or public deposits.
3. Trade Credit :
· Trade
credit is a credit extended on purchase of raw material or finished
goods on credit. The payment for purchased is to be made later on. Trade
credit does not include purchase of assets on credit.
· The credit
period range from 15 days to three months.
· Trade
credit is unsecured and the credit is allowed by sellers to
buyer based on the financial reputation of the buyer or trade practice in the
industry, financial strength of the buyer, nature of products etc.
Advantages
1. Simple
: Trade credit is convenient source of short term credit
and does not involve much formalities.
2. No
interest: No interest is payable for the period of credit.
3. No
security : The buyer is not required to give any security or
pledge assets.
4. Flexible : The
payment system is quite flexible and depends upon mutual agreement between the
seller and the buyer.
Disadvantages
1. Higher
prices: The prices of goods sold is generally higher when trade
credit is allowed.
2. Available
for short term : the maximum period of credit is only 3 months.
3. Possibility
of Bad Debts: The seller may have to bear the bad debts if the
buyer is unable to pay the amount.
4. Large
working capital: the sellers need to keep large amount of working
capital when he sells the goods on credit and allows longer credit period.
Installment Credit:
· It refers
to purchase of durable items like plant and machinery, furniture etc. on
credit.
· The buyer
has to pay part of the price at the time of taking delivery of goods, known as
down payment. The balance of the amount is to be paid in installments.
· The
seller/supplier charges interest on the balance due and interest is included in
the installment. In some cases, the credit is allowed through finance company
or commercial banks.
· The
physical possession of the asset is given to the buyer immediately on signing
of agreement and down payment but the ownership of the asset is transferred
only on payment of final instalment.
4. Factoring : (Accounts Receivable
Financing)
· Accounts
Receivable finance is defined as raising of funds through mortgage or sale of
Trade Receivables.
· In case of
mortgage of receivables, finance companies (factors) provide loans on the
security of these receivable, generally up to 60% of amount of such security.
The debtors of the firm may directly make payment to the finance company or to
the firm, which in turn will use that money to return the loan amount. Bad
debt, if any will be borne by the firm and not the finance company. The rate of
interest on such loans is quite high.
· In case of
outright sale of receivable, the finance company purchase debtors and
receivable at a heavy discount. The finance company, in turn will take the
entire responsibility of collecting the money and will be bad debts, if any.
Customer Advance:
· It
refers to that part of the price which is taken in advance from customers at
the time of booking or before the delivery of goods.
· A nominal
interest may be paid on such advance.
· When
delivery of goods is given to the buyer, the advance money is adjusted against
the price of the article.
· Advance
can only be taken from customers when the advance booking of the product is
done or the product is in high demand.
· The
advance received provide working capital to the firm.
5. Inter-Corporate Deposits:
· It refers
to deposits by one company with another company. In other words, Inter
corporate deposit is the process of borrowing of money by one company from
another company. A company having surplus money may lend to other companies
which may need financial assistance.
· Period
of Deposit: Maximum six months
· It
is a popular source of short-term finance.
· Procurement
procedure is simple.
· The
rate of interest on such deposits is not fixed. It depends upon the amount
involved and the tenure of lending.
· It
is uncertain source of finance, as deposit can be withdrawn any time—so it is
risky also.
Types:
Inter corporate deposits are
of three types:
1. Call Deposit:
Such a
type of deposit is withdrawn by the lender by giving a notice of one day.
However, in practice, a lender has to wait for at least 3 days.
2. Three-month Deposit:
As the
name suggests, such type of a deposit provides funds for three months to meet
up short-term cash inadequacy.
3. Six-month Deposit:
The
lending company provides funds to another company for a period of six months.
The advantages of
inter-corporate deposits are:
i. No
procedural Problems: These deposits do not involve any procedural problems
ii. Meeting
Short Term Requirements: Inter-Corporate deposits are a good source of meeting
short term funds requirements.
iii. Easy
Availability: These are easily available from companies, which have surplus
funds.
Disadvantages:
i. Short Term: Such deposits
are available only for short period.
ii. Higher Interest rates: The
rate of interest charged on such borrowings is quite
iii. These deposits can usually
be availed by reputed companies.
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