13 sources of finance

7/27/2019 13 Sources of Finance

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Dharmendra Gupta Classes(DGC) Source of Finance.13.1

SOURCES OF FINANCE

Q.1. How would you classify financial needs based on time facto!

Ans. The financial needs of a business can be classified as under :"y#e "ime $eiod E%am#les

Long Term Periods exceeding fiveyears

Investment in Fixed Assets viz. Land, uilding,Plant and !achinery, and in Permanent "or#ing$a%ital

!edium Term Above one year but lessthan five years

$osts of intensive advertising cam%aign or similardeferred revenue ex%enditure

&hort Term Less than one year Investment in current assets 'for (or#ing ca%italre)uirements.

Q.&. 'in( out t)e *aious a##oac)es of aisin( finance +o, How s)ould souces anda##lication of funds be matc)ed by an ente#ise !

The various a%%roaches to funding are:

Name of A##oac)

-atc)in(A##oac)

Conse*ati*eA##oac)

A((essi*e A##oac)

Long TermFunds used in

Fixed Assets andPermanent "or#ing$a%ital

Fixed Assets,Permanent "or#ing$a%ital and %art ofTem%orary "or#ing$a%ital

Fixed Assets and %art ofPermanent "or#ing $a%ital

&hort TermFunds used in

Tem%orary "or#ing$a%ital

alance %art of Tem%orary "or#ing$a%ital

alance %art of Permanent"or#ing $a%ital and entireTem%orary "or#ing $a%ital

Im%act onLi)uidity

$om%aratively (ell'balanced

*igh Li)uidity Lo( Li)uidity

Im%act onProfitability

$om%aratively (ell'balanced

Lo( %rofitability andreturn on assets

*igh return on assets but ris#y.

Q.. /ist some souces fom w)ic) finance can be aised.

Long Term &ources !edium Term &ources &hort Term &ources

+)uity &hare $a%ital

Preference &hare

$a%ital.

etained earnings.

-ebentures and onds

Long Term Loans from

Preference &hare $a%ital

-ebentures and onds

Public de%osits Fixed

de%osits for / year duration

!edium Term Loans from

financial institutions &tate

Trade credit ' &u%%liers.

Loans from $ommercial

ban#s.

Fixed de%osit for a %eriod

of 0 year or less

$ommercial Pa%ers

D-223, 2NDFloor Laxmi Chamber, Laxmi Nagar Delhi 92 Mo. 9810521310, 9968760918


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financial

Institutions, &tate

Financial

$or%orations or

$ommercial an#s

1enture $a%ital

assistance

Asset securitiesation

International financing

li#e +uro issues, Foreigncurrency loans.

Financial $or%orations or

$ommercial ban#s lease *ire ' %urchase financing

+xternal $ommercial

orro(ings

International financing li#e

+uro'issues, Foreign$urrency bonds

Advances received from

customers.

&hort Term unsecured

loans from

Q.0. )at ae t)e *aious bases on w)ic) financial souces of a business be classified!

The financial sources of a business can be categorised based on :

(a) "ime $eiod 2 Long Tern0 &ources, !edium Tern0 &ources and &hort Tern0 &ources as in /

above.+b, Ownes)i# 2

2(ners $a%ital '+)uity $a%ital, etained +arnings etc.

orro(ed $a%ital '-ebentures, Loans etc.

+c, Souces of 3eneation 2

Internal &ources 'etained +arnings, &in#ing Funds, -e%reciation +arnings etc.

+xternal &ources '-ebentures, Fresh issue of $a%ital etc.

Q.4. ite s)ot notes on E5uity Ca#ital as a souce of lon( tem finance.

A##licability 2 $om%anies registered under the Indian $om%anies Act, 0345, can raise finance by

(ay of +)uity $a%ital, sub6ect to the regulations laid do(n in the $om%anies Act, &+I 7uidelines andrelated la(s.

Featues2 The features of e)uity ca%ital are :

(a) Ris62 The shares are to be %aid off only u%on li)uidation. &o ris# is the least.

(b) Cost2 +)uity &hareholders are entitled to residual income, i.e. Profit after tax and theirex%ectations are high. Therefore, the cost of e)uity ca%ital is high.

(c) Contol2 +)uity &hareholders are the o(ners of the $om%any and have control over themanagement of the $om%any.

Ad*anta(es 2

2rdinary share ca%ital also %rovides a security 8e)uity base9 to other su%%liers of funds. &o, a

$om%any (ith a high %aid'u% e)uity ca%ital can raise further funds from other sources easily. It is a %ermanent source of finance. It is to be re%aid only in the event of li)uidation.

There are no committed %ayments to holders of e)uity shares. -ividends are discretionary and is

not mandatory li#e interest on debentures etc.

Q.7. ite s)ot notes on $efeence S)ae Ca#ital as a souce of lon( tem finance.

-eanin(2 These are a s%ecial #ind of shares (here the shareholders en6oy %riority or %reference overe)uity shareholders, as regards:



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8a9 Payment of dividend at a fixed rate and

8b9 e%ayment of $a%ital on the (inding u% of the com%any

Featues 2

Cumulati*e O#tion2 Preference shares may be issued as cumulative, i.e., the dividend %ayable in

a year of loss, gets carried over to subse)uent years till there are ade)uate %rofits to %ay theaccumulated dividends. ;on'cumulative %reference shares may also be issued.

Redeemability and Con*etibility2 7enerally, %reference shares carry a sti%ulation of re%aymentat the end of a time %eriod., &ometimes, they may carry the o%tion of conversion into e)uity shareca%ital also.

$efeence 8i*idend2 The rate of dividend on %reference shares is normally higher than the rate

of interest on debentures, loans etc. This is an a%%ro%riation of %rofits and not a charge against%rofits.

Hybid Fom of financin(2 Preference $a%ital has features of both debt and e)uity. It can be

com%ared (ith debt since the rate of dividend is fixed and the ca%ital is re%ayable at the end of a%eriod. It can also be li#ened to e)uity because dividend is not tax'deductible.

Ad*anta(es 2

There is no dilution of +P& on the enlarged ca%ital base. Issue of further e)uity ca%ital (ill reducethe +P& and affect mar#et %erce%tion about the com%any'

There is leveraging advantage as it bears a fixed charge.

There is no ris# of ta#eover or loss of control.

Preference ca%ital can be redeemed after a s%ecified %eriod.

Q.9. How can a Com#any effecti*ely use Retained Eanin(s as a souce of finance !

8a9 It is a general %ractice of $om%anies to accumulate %rofits and %lough them bac# into business.&uch accumulated %rofits are called etained +arnings. They belong to the e)uity shareholdersand increase the ;et "orth of the com%any.

8b9 +nter%rises must hold bac# or retain a reasonable amount of %rofit every year for their ex%ansion%lans, and other legal re)uirements in this regard.

8c9 etained +arnings entail almost no ris#. There is no dilution of control in retaining %rofits.

8d9 +xisting %rofit ma#ing com%anies that underta#e an ex%ansion diversification %rogramme shouldinvest a %art of their accumulated reserves or cash %rofits for creation of ca%ital assets. In other(ords, the sur%lus generated from o%erations, after meeting all the contractual, statutory and(or#ing re)uirements of funds, is available for further ca%ital ex%enditure.

Q.:. ite s)ot notes on 8ebentues and 'onds as a souce of lon( tem finance.

Featues2

809 Public Limited $om%anies raise funds from %ublic by issuing 9 -ebentures are issued (ith ne( inventive schemes li#e (arrants, o%tions, convertibility etc.

849 The %ublic issue of debentures is made sub6ect to &+I guidelines.

859 $redit ating is com%ulsory for %ublic issue of debentures or %rivate %lacement to mutual funds.



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The rating is based on trac# record, %rofitability, debt servicing ca%acity, credit (orthiness and theris# of lending.

Ad*anta(es of debentues 2

809 $ost of -ebt $a%ital is lo(er (hen com%ared to e)uity or %reference ca%ital. Thus 7earing isadvantageous.

8=9 -ebenture financing does not result in dilution of control.

8/9 In a %eriod of rising %rices, debenture issue is advantageous. The fixed monetary outgo decrcasesin real terms as the %rice level increases.

8isad*anta(es of debentue financin( ae2

809 -ebenture interest and ca%ital re%ayment are obligatory %ayments.

8=9 There may be restrictive covenants in a -ebenture Trust -eed.

8/9 -ebenture financing enhances the financial ris# associated (ith the firm.

Q.;. ite s)ot notes on /on( "em /oans fom Financial Institutions and Commecial 'an6s.

Institutions2 &%ecialised Financial Institutions and $ommercial an#s %rovide long term financialassistance to industry. &ome of these institutions are: the Industrial $redit and Investment $or%orationof India 8I$I$I9, the Industrial Finance $or%oration of India 8IF$I9, the &tate Financial $or%orations8&F$9, the Life Insurance $or%oration of India 8LI$9, the ;ational &mall Industries $or%oration Limited8;&I$9.

$o


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Q.11. ite S)ot Notes on >entue Ca#ital Financin(. ?No*.&==&@

-eanin(2 1enture $a%ital Financing refers to financing of high ris# ventures %romoted by ne(,)ualified entre%reneurs (ho re)uire funds to give sha%e to their ideas. *ere, a financier 8called1enture $a%italist9 invests in the e)uity or debt of an +nter%reneur 8Promoter 1enture $a%ital?nderta#ing9 (ho has a %otentially successful business idea, but does not have the desired trac#record or financial bac#ing.

7enerally, venture ca%ital funding is associated (ith heavy initial investment businesses li#eenergy conservation, )uality u% gradation or (ith sunrise sectors li#e information technology.

1enture $a%ital $om%any 1enture $a%ital Assistance 1enture $a%ital ?nderta#ingIn*esto $omote Ente#eneu

-et)ods of *entue ca#ital financin( 2

8i9 E5uity financin(2 The 1enture $a%ital ?nderta#ings generally re)uire funds for a longer%eriod but may not be able to %rovide returns to the investors during initial stages. *ence,e)uity share ca%ital financing is advantageous. The investor@s contribution does not exceed >3 of the total e)uity ca%ital of the underta#ing. *ence, the effective control and o(nershi%remains (ith the entre%reneur.

8ii9 Conditional loan 2A conditional loan is re%ayable in the form of a royalty after the venture isable to generate sales. ;o interest is %aid on such loans. The rate of royalty may rangebet(een = and 04 based on factors li#e gestation %eriod, cash flo( %atterns, extent of ris#,etc. &ometimes, the entre%reneur has a choice of %aying a high rate of interest 8say =B9instead of royalty on sales once the activity becomes commercially sound.

8iii9 Income note2 It is a hybrid ty%e of finance, (hich combines the features of both conventionalloan and conditional loan. The entre%reneur has to %ay both interest and royalty on sales but atsubstantially lo( rates.

8iv9 $atici#atin( debentues2 Interest on such debentures is %ayable at three different ratesbased on the %hase of o%erations as under :

8a9 &tart u% %hase ';IL Interest

8b9 ;ext stage 'Lo( rate of interest

8c9 After a %articular level of o%erations '*igh rate of interest.

Q.1&. )at do you undestand by 8ebt Secuitisation !

-eanin(2 It is a mode of financing (herein securities are issued on the basis of a %ac#age of assets8called Asset Pool9. In this method of recycling funds, assets generating steady cash flo(s are%ac#aged together and against this asset %ool, mar#et securities can be issued.

$ocess2 The debt securitisation %rocess has the follo(ing functions activities :

8i9 The 2rigination Function: A borro(er see#s a loan from a lending institution 8finance com%anyor ban#9. The credit (orthiness of the borro(er is evaluated and the loan is sanctioned. A

contract is signed bet(een the %arties, (ith re%ayment schedule s%read over the life of theloan. The lender is called the 2riginator, to (hom the loan constitutes an asset 8receivable9.

8ii9 The Pooling Function: The 2riginator 8Lender9 clubs together similar loans or receivables, tocreate an underlying %ool of assets. This %ool is transferred in favour of a &P1 8&%ecialPur%ose 1ehicle9, (hich acts as a trustee for the investor. 2nce the assets are transferred, theyare held in the 2riginators@ %ortfolios.

8iii9 The &ecuritisation Function: ;o(, the &P1 issues securities on the basis of the asset %ool. Thesecurities carry a cou%on and an ex%ected maturity, (hich can be asset based or mortgagebased. These are generally sold to investors through merchant ban#ers.



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Featues 2

8a9 7enerally institutional investors li#e mutual funds 8not individuals9 are interested in -ebt&ecuritisation.

8b9 The 2riginator usually #ee%s the s%read available 8i.e.difference9 bet(een yield from securedassets 8interest received from borro(er9 and interest %aid to investors 8of securities9. Thisconstitutes originator@s income.

8c9 The securitisation %rocess is generally (ithout recourse i.e. the investor bears the credit ris# orris# of default and the issuer is under an obligation to %ay to investors only if the cash flo(s arereceived by him from the asset %ool.

8d9 The 2riginator ho(ever, has a right to legal recourse against the borro(er in the event of default.

8e9 The ris# run by the investor can be further reduced through credit enhancement facilities li#einsurance, letters of credit and guarantees.

8f9 In a sim%le


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Dharmendra Gupta Classes(DGC) Source of Finance.13.

Q.1. 'in( out t)e ole of /ease Financin(.

-eanin(2 Leasing is a contract (here one %arty 8o(ner Lessor Leasing $om%any9 %urchases theassets and %ermits its use by another %arty 8Lessee9 over a s%ecified %eriod of time. Thus, leasing isan alternative to the %urchase of an asset out of o(n or borro(ed funds.

Consideation2 The Lessee %ays a s%ecified rent at %eriodical intervals as consideration for the useof the asset. The Lessee claims Lease ental $harges as his revenue ex%enses. The Lessor is

entitled to claim de%reciation as he is the o(ner of the asset.Ad*anta(es to /essee 2

Immediate $ash 2utflo( i.e. investment in $a%ital Asset is eliminated.

Lease entals are tax deductible ex%enses.

$.10. riefly describe Trade $redit and Advances as sources of &hort Term finance.

"RA8E CRE8I" 2

Featues 2

It re%resents credit granted by su%%liers of goods, in the normal course of business.

The duration of such trade credit is based on various factors including %revailing %ractices, and isusually bet(een 04 to 3B days.

It is common to a0most all business o%erations.

It can be in the form of an @o%en account@ or bills %ayable.

Ad*anta(es 2

There is no ex%licit cost associated (ith $redit Period availed.

It is available and #ee%s on rotating as long as the business is a going concern.

It enhances automatically (ith the increase in the volume of business.

A8>ANCES FRO- CUS"O-ERS 2

In certain areas of activity, it is usual business %ractice to obtain advance money from customers. Thisis a%%licable (hen the goods are costly or (hen considerable time %eriod is involved. For exam%le,

$onstruction of a bridge building

!anufacture of a s%ecialised e)ui%ment involving heavy cost based on customer@s re)uirements

This is a cost free source of finance and hence substantially useful.

Q.14. )at ae *aious foms in w)ic) s)otB tem finance can be obtained fom 'an6s !

3eneal Featues 2

8a9 an# advances are in the form of loan, overdraft, cash credit and bills %urchaseddiscounted etc.

8b9 The terms, conditions and norms for lending are based on the general %olicy laid do(n by the Iand also by the schemes of the concerned an#.

8c9 Advances are granted against securities (hich can be classified as:

$imay Secuity 2 *y%othecation of stoc#s, boo# debts, e)uitable mortgage of fixed assets,

Pro'notes etc.

Collateal Secuity 2+)uitable mortgage of Land, uildings or other %ro%erty belonging to the

enter%rise or its %romoters.

3uaantees2 Personal 7uarantees of the concerned %romoters, %artners or -irectors



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Dharmendra Gupta Classes(DGC) Source of Finance.13.!

+1, /oans2

8a9 It is a single advance, (herein the entire amount of loan is disbursed at one time by transfer tothe current account of the borro(er.

8b9 Interest and other charges li#e ins%ection, insurance, %rocessing charges etc. are charged tothis account.

8c9 e%ayment of instalments by the borro(er as %er the agreed schedule is credited to this

account.8d9 Loan accounts are not running accounts li#e overdraft and cash credit accounts.

+&, O*edaft2

8a9 ?nder this facility, a fixed limit is granted (ithin (hich the borro(er is allo(ed to overdra( fromhis account.

8b9 Technically, overdrafts are re%ayable on demand, but they generally continue for longer%eriods by annual rene(al of limits.

8c9 The borro(er can use and dra( u%to the extent of limit sanctioned, according to hisre)uirements. Interest is charged on daily balances.

8d9 These accounts are o%erative li#e cash credit and current accounts and hence che)ue boo#s

are %rovided.+, Clean O*edafts 2

8a9 A $lean 2verdraft refers to an advance by (ay of overdraft facility, but not bac#ed by anytangible security.

8b9 *ence, re)uest for clean advances are entertained only from %arties, (hich are financiallysound and re%uted for their integrity. The an# has to rely u%on the %ersonal security of theborro(ers.

8a9 &ome factory to be considered by the an# before granting clean 2-@s are 8a9 Past o%erationsof the %arty 8b9 Turnover in the account 8c9 &atisfactory dealings for considerable %eriod and8d9 e%utation in the mar#et

8b9 As a safeguard, ban#s ta#e guarantees from other %ersons (ho are credit. "orthy before

granting this facility.

8c9 A clean advance is generally granted for a short %eriod and must not be continued for long.

+0, Cas) Cedits 2

8a9 It is an arrangement under (hich a customer is allo(ed an advance u% to certain limit againstcredit granted by ban#.

8b9 The customer need not borro( the entire amount of advance at one time he can only dra( tothe extent of his re)uirements and de%osit sur%lus funds in his account.

8c9 Interest is charged only on the amount actually availed of by the customer and not on the fullamount.

8d9 7enerally cash credit limit are sanctioned against %ledge or hy%othecation of goods.

8e9 Technically, $ash $redit Advances are re%ayable on demand, but these are continued andalso enhanced from time'to'time by the borro(er and the ban# as %art of (or#ing ca%italfinancing.

+4, Ad*ances a(ainst (oods2

8a9 ?nder this arrangement, a an# grants advance as a %ercentage of value of goods offered assecurity.

8b9 The term @goods@ includes all forms of movables (hich are offered to the ban# as security.They may be agricultural commodities or industrial ra( materials or %artly finished goods.



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Dharmendra Gupta Classes(DGC) Source of Finance.13."

8c9 "hen goods are %rovided as security, they %rovide a reliable source of re%ayment. Advancesagainst them are safe and li)uid. Also, there is a )uic# turnover in goods, as they are inconstant demand.

8d9 7enerally goods are charged to the ban# either by (ay of %ledge or by (ay of hy%othecation.

8e9 For the %ur%ose of calculation of dra(ing limits, valuation of the goods is made from time totime. The ban# also ta#es %eriodical statements of stoc#s from the borro(er.

+7, 'ills $uc)ased 8iscounted 28a9 These advances are allo(ed against the security of bills, (hich may be clean or documentary.

8b9 This arrangement o%erates as under :

orro(er 8manufacturer9 su%%lies goods to his customers and raises su%%ly bills 8invoices9

on them, falling due for %ayment on a future date.

The ban# discounts su%%ly bills 8invoices9 by %aying the amount of the bill after deducting

its margin and discounting charges. For exam%le, for a bill of s.0BBB, the ban# mayadvance s.DEB 8s.lBBB less 0B margin s.lBB less discounting charges s./B9.

?%on collection of amount due from the customer, the ban# ta#es the full amount of the bill

and credits the balance amount earlier (ithheld as margin. In the above case, the ban#

may credit s.3=' 8s. 0BB margin less $harges s.D9. The difference bet(een the amounts collected 8s.0BBB9 and the amounts credited

8s.DEB s.3=9 re%resents earnings of the ban#ers for the %eriod. This item of income iscalled @discount@.

8c9 Although the term @bills %urchased@ gives the im%ression that the ban# becomes the o(ner or%urchaser of such bills, in actual %ractice the ban# holds bills only as security for advance. Theborro(er is ultimately liable on the advance, in case of default by the customer. The ban#, inaddition to the rights against the %arties liable, can also exercise a %ledgee@s rights over goodscovered by the documents.

8d9 &ometimes, overdraft or cash credit limits may also be allo(ed against the security of bills,after maintaining a suitable margin. *ere the bill is not a %rimary security but only a c

collateral security. The ban#er in the case, does not become a %arty to the bill, but merely iGcollects it as an agent for its customer.

+9, Ad*ance a(ainst documents of title to (oods 2

8a9 A document becomes a document of title to goods (hen its %ossession is recognised by la(or business custom as %ossession of the goods.

8b9 +xam%les of documents of title to goods are bill of lading, (arehouse #ee%er@s certificate,

13 sources of finance

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