Sources of Finance & Importance Of Working

Capital Management

Ch.NareshSMCDC - BBA

1.Sources Of Finance

Contents :➢Finance➢Shares➢Debentures➢Bonds➢Right shares➢Venture capital➢Mutual fund

2.Working capital Management :

Contents :

➢Meaning➢Importance of

Working capital ➢Types of Working

capital ➢Components Of

Working Capital

FinanceThe Term Finance Is Derived From The Latin Word ‘Finis’. Finance Can Also Be Interpreted In Many Ways Such As Fund, Money, Investment, Capital, Amount, Etc.,

Why Do We Need Finance

Finance Acts As A Medium For Business Which Involves The Acquisition Of Funds In Various Departments Such As

Production DepartmentPurchase DepartmentResearch And Development.

Classification According To Terms Of Finance

➢Short Term Finance

➢Medium Term Finance

➢Long Term Finance

Short Term Finance

➢Short term finance are required primarily to meet working capital requirements.

➢The focus is on maintaining liquidity at a reasonable cost.

Short term

finance

Working Capital Finance

By Commercial Banks

Trade Credit

Inter-corpora

te Deposit

s

Factoring

Commercial Paper

1.Working capital finance by commercial banks -Bank Credit may be granted in the following ways:- Loans Purchase/ Discounting of bills. Cash Credit Over draft

2.Trade Credit

-Trade credit represents credit granted by the suppliers of goods, etc. as an incident of sale.

3.Inter corporate Deposits

-A deposit made by one company to another is called as inter-corporate deposit. It is generally for working capital funding & is for period not exceeding six months.

4.Factoring

-Factoring is an agreement in which receivable arising out of sale are sold by a firm (client) to the factor (a financial intermediary).

5.Commercial Paper

-. Commercial paper is an unsecured money market instrument issued in the form of a promissory note

Medium Term Loan

➢Medium term finance is defined as money raised for a period for 1 to 5 years.

➢The medium term funds are required by a business mostly for the repaired and modernizing of machinery.

Medium

Term Loan

Lease Financin

g

Hire Purchas

e

External Commerci

al Borrowing

s

Euro Bond

s

Commercial Banks & State

Financial Institutio

ns

1. Lease Financing

It is a contract In which the assets is purchased initially by the lessor(leasing company) and thereafter leased to the user(lease company) who pays a specified rent at periodical intervals.

2. Hire Purchasing

Hire purchase transaction, the goods are delivered by the owner to another person the agreement that such person pays the agreed amount in the periodical installment.

3. EXTERNAL COMMERCIAL BORROWING

ECBs mean foreign currency loan raised by residents from recognized lenders. Financial leases and Foreign Currency Convertible Bonds are also covered by ECB guidelines.

4. Euro bonds

A bond issued in a currency other than the currency of the country or market in which it is issued.

5. Commercial Banks & State Financial

Money which is obtained through Commercial Banks & State Financial

Long Term Finance

Long term finance refer to those requirements of funds which are for a period exceeding 5-10 years.

Long term

finance

Share

Debentures

New Debt Instrumen

ts

Retained Earnings

Depository Schemes

Venture Capital

Securitization

1.Shares : A shares indicates a smaller unit into which the overall requirement of a company is subdivided.2. Debentures : It means a document containing acknowledgement of indebtedness issued by a company and giving an undertaking to repay the debt at a specified date. 3. New Debt Instrument :

➢Zero interest bond (ZIB)➢Deep discount bonds (DDB)➢Junk bonds➢Convertible debenture

4. Retained Earnings : Retained earnings means that part of trading profits which is not distributed in the form of dividends but retained by directors for future expansion of the company.

5.Depository Schemes➢ GDRs :- (Global Depository Receipt) A negotiable certificate held in the bank of one country representing no. of shares traded on the exchange of another country.➢ ADRs :- (American Depository Receipts) It allows US investors to buy shares of ADS companies without the cost of investing directly in Foreign Stock Exchange.➢ IDRs :- (International Depository Receipt) It allows foreign companies to raise the funds from Indian markets.

6. Ventures : The venture capital financing refers to financing & funding of the small scale enterprises, high technology & risky volumes.

7. Securitization : It is a process in which illiquid assets are pooled into marketable securities that can be sold to investors.

Some Important Sources Of Finance

1. Seed capital assistance :

Designed by IDBI.1% service charge for 5 years.

2. Certificate of deposit :

The main advantage of CD is the banker is not required to encash the deposit before maturity period and the investor is assured of liquidity because he can sell the CD in secondary market.

3. Internal cash accrual :

Existing profit making companies which undertake an expansion program may be permitted to invest a part of their accumulated reserves or cash profit for creation of capital assets.

Shares

Equity Shares

Preference SharesSha

res

Equity Shares

➢An equity share, commonly referred to as ordinary share also represents the form of fractional or part ownership in which a shareholder, as a fractional owner, undertakes the maximum entrepreneurial risk associated with a business venture. The holders of such shares are members of the company and have voting rights.

➢A company may issue such shares with differential rights as to voting, payment of dividend, etc. 

Sample Copy Of Equity Share

Merits of equity shares

➢ Company need not have the forced obligation to pay dividend to equity shareholders.

➢ Equity share is a permanent source of funds which facilitate flexibility in usage of funds.

➢ The obligation to repay the equity capital arises only at the time of liquidation of the company.

➢ The shareholders can participate in the management of the company through voting rights.

➢ Equity shares can be issued without creating any charge over the assets

Demerits of Equity Shares

➢ Equity shares always associated with the expectations of the investors. It is practically a difficult task to fulfill the expectations of the investors.

➢ Equity shareholders have to bear all the losses at the time of liquidation. Interruptions of many persons are involved in the company working. So, in some cases, it creates delay in decision-making.

➢ When the finance has to be raised for less risky projects, then this is not a good source of raising finance. If only equity shares are issued then the company can not avail the benefits of trading on equity. Investors who have a desire to invest in safe or fixed returns have no attraction of such shares.

Features of Equity Shares

1. Right to income

2. Right to control

3. Pre-emptive Right

4. Right to Liquidation

1. Right to income :

The equity investors have residual claim to the income of company. The income left after satisfying the claims of all other investors belongs to equity shareholder. This income is simply equal to profit after tax minus preference shares dividend. The income of equity shareholders may be retained by the firm or paid out as dividends.Equity earnings which are retained in firm tend to increase market value of equity shares & earnings distributed as dividend provide current income to equity shareholders

2. Right to control

Equity shareholders are owners of the firm. So they can elect the board of directors & have right to vote on every resolution passed before the company. The board of directors selects the management & management controls the operations of firm. Hence, equity shareholders indirectly control the operation of firm.

3. Pre-emptive Right

The pre- emptive right enables existing shareholders to maintain their proportional ownership by purchasing the additional equity shares issued by company. According to law, existing shareholders have first priority to purchase additional shares on pro rata basis before the others. Ex. if company has 10,00,000 outstanding shares of equity & proposes to issue 3,00,000 additional equity shares, an equity shareholder owing 100 shares has the first right to purchase 30 of 3,00,000 new shares before those are offered to anyone else

4. Right to Liquidation

Equity shareholders have a residual claim over the assets of the firm in the event of liquidation. Claims of all others- debenture holders, secured lenders, unsecured lenders, other creditors, & preference shareholders – are prior to the claim of equity shareholders

Evaluations from the view point of Company:

➢ Advantages :

1. Permanent capital :

It represents permanent capital. Hence there is no liability for repayment.

2. No obligation to pay dividend :

Equity shares impose no obligation on the company to pay a fixed dividend to the equity shareholders. They get dividend if adequate profits are available.

3. No charge on property :

The company is able to procure capital without creating charges on its property, which remain free & can be utilized when additional funds are required by the company.

4. Wide scope of marketability :

Equity shares are lower denominations, hence they can be purchased by persons of limited income also. So there is a wide scope of marketability of equity shares.

5. High credit worthiness :

The equity capital increases the company’s financial base & thus it’s borrowing limit increase. Lenders generally lend in proportion to the company’s equity capital. By issuing Equity shares, the company increases its financial capability. It can borrow when it needs additional funds.

6. High premium :

The company can easily sell equity shares on premium in times of boom. Even in such circumstances , people are most eager to buy equity shares. Hence company can easily & quickly raise fixed capital through equity shares.

Evaluations from the view point of Company:

Disadvantages:

1. Cost of equity :

Cost of equity is generally highest. The rate of return required by equity shareholders is generally higher than rate of return required by other investors.

2. Floatation cost :

Floatation cost means cost of issuing equity shares, which is higher than cost of issuing other types of securities. Underwriting commission , brokerage costs & other issue expenses are higher for equity capital.

3. Interference in management :

Equity shareholders have voting rights. Hence there may be interference in existing pattern of management.

4. Speculation :

There are the higher chances of speculation because it is traded in stock market.

5. Dividend is not tax deductible :

Equity share dividend is not tax deductible payment

6. Dilution of control :

Sale of Equity shares to outsiders may result in dilution of control of existing shareholders

Preference Shares

➢ Preference share holders have no voting rights ; so they have no say in the management of the company.

➢ A fixed rate of dividend is paid on preference share capital.

Sample Copy Of Preference Share

Types Of Preference Shares

1. Cumulative preference share2. Non cumulative preference share3. Redeemable preference share4. Irredeemable preference share5. Participating preference share6. Non participating preference share7. Convertible preference share8. Non convertible preference share

1. Cumulative Preference Shares : These share holders have a right to claim dividend for those years also for which there are no profits.

2. Non-Cumulative Preference Shares : These share holders are paid dividend if there are sufficient profits.

3. Redeemable Preference Shares : These shares are issued on the terms where they are liable to be redeemed at either a fixed time, or the company's option or at the shareholders option. In other words, the company can buy back preference shares at an agreed time and price.

4. Irredeemable Preference Shares : Those shares which cannot be redeemed unless the company is liquidated.

5. Participating Preference Shares : The holders of these shares participate in the surplus profits of the company.

6. Non-Participating Preference Shares : They do not have such rights to participate or claim for a part in the surplus profits of a company.

7. Convertible Preference Shares : The holders of these shares may be given a right to convert their holding into equity shares after a specific period.

8. Non-Convertible Preference Shares : Those shares which cannot be converted into equity shares are known as non-convertible preference shares.

Features

➢Maturity:- Preference Shares generally resembles with equity shares in case of maturity. The company is required to repay the amount only at the time of liquidation of the company, after meeting the claim of creditors but before paying back the equity share holders.

➢Claims on Income:- Whenever the company has distributable profit, firstly, a fixed rate of dividend is paid to preference share holders.

➢Claims on Assets:- Usually, the preference share holders do not have any right in the surplus assets of the company. However, company may issue participating preference shares which entitle its holder to participate even in the surplus assets of the company at the time of liquidation in agreed ratio.

➢Control:- Ordinarily, Preference Share holders do not have any voting rights, so they do not have any say in the management or control of the company.

Advantages

The company has many advantages by issuing preference shares, like-

➢ No legal obligation to pay dividend

➢ Preference Shares provides long term capital for the company.

➢ No liability to redeem during lifetime of company.

Investors or Shareholders in preference shares enjoy the following advantages:

➢ Fixed rate of dividend

➢ Superior security over equity shares

➢ Preferential rights in regard to payment of dividend

Disadvantages

The company has following disadvantages :-

➢ It is an expensive source of finance.

➢ Cumulative Preference Shares became a permanent burden.

➢ Dividend on preference shares is non deductible expense.

Investors suffers from the following demerits of preference shares:-

➢ Preference Shareholders do not have any voting right in the management.

➢ Rate of dividend is usually lower than equity shares.

➢ The market prices of preference shares fluctuate much more than that of debentures

Debentures

➢ Debenture holders are not the owners of the company. They are considered the creditors of the corporation or in other words, the company borrow money from them through issuing debenture.

➢ It is a long-term debt instrument or security.

➢ It is also known as BOND.

➢ Bond issued by government do not have any risk of default.

➢ A company in India can issue secured or unsecured debentures.

➢ In case of debentures, the rate of debentures are fixed and known to investors.

PURPOSE OF ISSUING DEBENTURES

➢For setting up a new project.

➢Expansion or diversification of Existing project.

➢Normal capital expenditure for modernization.

➢Merge of companies.

Features➢ Date of Maturity: For all the non convertible and

redeemable debentures, the issuing company has to issue repayment to the debenture holders on the date of maturity. This date is also mentioned on the certificates and it infers the total time for which the money is invested by the lenders which is interval between the date of issue to the date of maturity.

➢ Charge on Assets and Profits in case of Default: The debenture holders may have claims over the profits and assets of the company in case the company has defaulted in the payment of either the interest or the capital repayment.

➢ Convertibility: Certain types of debentures are issued with the option of conversion into equity. The ratio of conversion and the time period after which conversion will take place is mentioned in the agreement of debenture. Debentures may be fully or partly convertible in nature.

➢ No voting rights: The debenture-holder is not a shareholder and cannot vote in the company's general meetings.

➢ Fixed rate of interest: A debenture with a fixed charge has a fixed rate of interest. It can be presented as "10% Debenture". They are always unsecured and earns a fixed rate of interest but has no share of the profit.

➢ Control: Since, debentures holders are creditors of the company and not its owners, they do not have any control over the management of the company. They do not have any voting rights to elect the directors of the company or on any other matters. But, at the time of the liquidation of the company they have prior claim over share holders and if remain unpaid, they may take control over the company.

Types of debentures

➢Secured debentures.➢Unsecured debenture.➢Redeemable debentures.➢Perpetual debentures.➢Convertible debenture.➢Non-convertible debenture.➢Coupon rate debenture.➢Zero coupon debenture.➢Registered debenture.➢Bearer debenture

Bonds

Bonds refer to debt instruments bearing interest on maturity. In simple terms, organizations may borrow funds by issuing debt securities named bonds, having a fixed maturity period (more than one year) and pay a specified rate of interest (coupon rate) on the principal amount to the holders. Bonds have a maturity period of more than one year which differentiates it from other debt securities like commercial papers, treasury bills and other money market instruments.

TYPES OF BONDS

Municipal Bonds:

Municipal bonds are debt obligations issued by states, cities, countries and other governmental entities, which use the money to build schools, highways, hospitals, sewer systems, and many other projects for the public good.

When you purchase a municipal bond, you are lending money to a state or local government entity, which in turn promises to pay you a specified amount of interest (usually paid semiannually) and return the principal to you on a specific maturity date.

Not all municipal bonds offer income exempt from both federal and state taxes. There is an entirely separate market of municipal issues that are taxable at the federal level, but still offer a state—and often local—tax exemption on interest paid to residents of the state of issuance. Most of this municipal bond information refers to munis which are free of federal taxes.

Government Bonds:

Government Bonds are securities issued by the Government for raising a public loan or as notified in the official Gazette. They consist of Government Promissory Notes, Bearer Bonds, Stocks or Bonds held in Bond Ledger Account. They may be in the form of Treasury Bills or Dated Government Securities.

Mortgage and Asset Backed Bonds:

Mortgage-backed securities (MBS) and Asset-backed securities (ABS) represent the largest segment of the global bond market today. In simple terms, investing in MBS means lending your money to hundreds of individual mortgage borrowers across the country. In return for a higher yield than Treasury notes, investors are subject to added "prepayment" risk, meaning money invested may be repaid much sooner than maturity.

Corporate Bonds

Corporate bonds are debt obligations issued by private and public corporations. They are typically issued in multiples of 1,000 and/or 5,000. Companies use the funds they raise from selling bonds for a variety of purposes, from building facilities to purchasing equipment to expanding their business.

Zero Coupon Bonds

Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their face value, which is the amount a bond will be worth when it "matures" or comes due. When a zero coupon bond matures, the investor will receive one lump sum equal to the initial investment plus the imputed interest

Risks of Investing in Bonds

Interest rate risk When interest rates rise, bond prices fall; conversely, when rates decline,

bond prices rise. The longer the time to a bond’s maturity, the greater its interest rate risk.

Reinvestment risk When interest rates are declining, investors have to reinvest their interest

income and any return of principal, whether scheduled or unscheduled, at lower prevailing rates.

Inflation risk Inflation causes tomorrow’s rupee to be worth less than today’s; in other words,

it reduces the purchasing power of a bond investor’s future interest payments and principal, collectively known as “cash flows.” Inflation also leads to higher interest rates, which in turn leads to lower bond prices.

Market risk The risk that the bond market as a whole would decline, bringing the value of

individual securities down with it regardless of their fundamental characteristics.

Default risk The possibility that a bond issuer will be unable to make interest or principal

payments when they are due. If these payments are not made according to the agreements in the bond documentation, the issuer can default

Venture capital

➢It’s a private funding used to support risky new business and speculative ventures, usually with high growth potential.

➢A typical venture capital investment usually involves the business owner giving up equity to venture capitalist in return for funding.

Venture capital funding

➢Venture capitalists are typically very selective in deciding what to invest in;

➢Funds are most interested in ventures with exceptionally high growth potential, providing the financial returns and successful exit event within the required timeframe (typically 3–7 years) that venture capitalists expect.

➢Young companies to raise venture capital require a combination of innovative technology, potential for rapid growth, a well-developed business model, and an impressive management team.

Disinvestment

➢Time of exit from the firm’s capital is almost never predetermined, but depends on the development of the company.

➢ In successful cases, divestments take place when the company has reached the level of expected development and the value of the company and thus the membership, has consequently increased.

➢ Disinvestments happens when the conviction that is no more possible to solve the situation created takes hold.

Mutual fund

➢ A mutual fund is a common pool of money into which investors place their contributions that are to be invested in different types of securities in accordance with the stated objective.

➢ An equity fund would buy equity assets – ordinary shares, preference shares, warrants etc.

➢ A bond fund would buy debt instruments such as debenture bonds, or government securities/money market securities.

➢ A balanced fund will have a mix of equity assets and debt instruments.

➢ Mutual Fund shareholder or a unit holder is a part owner of the fund’s asset.

Process

Fund Structure Fund Sponcer Sponsor

Trustee

Asset Management Company

Depository

Custodian

Agent

Advantages of Mutual Funds➢ Liquidity: Investors may be unable to sell shares directly, easily and quickly. When they invest in mutual funds, they can cash their investment any time by selling the units to the fund if it is open-ended and get the intrinsic value. Investors can sell the units in the market if it is closed-ended fund.

➢ Convenience and Flexibility: Investors can easily transfer their holdings from one scheme to other, get updated market information and so on. Funds also offer additional benefits like regular investment and regular withdrawal options.

➢ Transparency: Fund gives regular information to its investors on the value of the investments in addition to disclosure of portfolio held by their scheme, the proportion invested in each class of assets and the fund manager's investment strategy and outlook

Disadvantages of Mutual Funds

➢ No control over costs: The investor pays investment management fees as long as he remains with the fund, even while the value of his investments are declining. He also pays for funds distribution charges which he would not incur in direct investments.

➢ Managing a portfolio of funds: Availability of a large number of funds can actually mean too much choice for the investor. So, he may again need advice on how to select a fund to achieve his objectives.

➢ Delay in redemption: It takes 3-6 days for redemption of the units and the money to flow back into the investor’s account.

Working Capital Management

Definition Of Working Capital 

In An Ordinary Sense, Working Capital

Denotes The Amount Of Funds Needed For

Meeting Day-to-day Operations Of A

Concern.

Need/Importance of Working Capital

➢ It helps measure profitability of an enterprise. In its absence, there would be neither production nor profit.

➢ Without adequate working capital an entity cannot meet its short-term liabilities in time.

➢ A firm having a healthy working capital position can get loans easily from the market due to its high reputation or goodwill.

➢ Sufficient working capital helps maintain an uninterrupted flow of production by supplying raw materials and payment of wages.

➢ Sound working capital helps maintain optimum level of investment in current assets.

➢ It enhances liquidity, solvency, credit worthiness and reputation of enterprise.

➢ It provides necessary funds to meet unforeseen contingencies and thus helps the enterprise run successfully during periods of crisis.

KINDS OF WORKING CAPITALWORKING CAPITAL

BASIS OF CONCEPT

BASIS OF TIME

Gross Working Capital

Net Working Capital

Permanent / Fixed

WC

Temporary / Variable

WC

Regular WC

Reserve WC

Special WC

Seasonal WC

Basis of concept

➢Gross working capital

➢Net working capital

2.Net Working Capital:

The difference between current assets and current liabilities of a business con cern is termed as the Net working capital.

Net working capital = Stock + Debtors + Receivables + Cash – Creditors – Payables.

1.Gross Working Capital:

The sum total of all current assets of a business concern is termed as gross working capital.

Gross working capital = Stock + Debtors + Receivables + Cash.

Basis Of TimePermanent Working Capital

➢ Regular Working Capital

➢ Reserve Working Capital

Temporary Working Capital

➢ Seasonal Working Capital

➢ Special Working Capital

Permanent/Fixed Working Capital

A Part Of The Investment In Current Assets Is As Permanent As The Investment In Fixed Assets. It Covers The Minimum Amount Necessary For Maintaining The Circulation Of The Current Assets. Working Capital Invested In The Circulation Of The Current Assets And Keeping It Moving Is Permanently Locked Up.It is again sub divided into two:1) Regular Working Capital2) Reserve Working Capital

1. Regular working capital:It is the minimum amount of liquid capital required to keep up the circulation of the capital from cash to inventories to receivables and back again to cash. This would include a sufficient amount of cash to maintain reasonable quantities of raw materials for processing into finished goods to ensure quick delivery etc.

2. Reserve margin or cushion working capital:It is extra capital required to meet unforeseen contingencies that may arise in future. These contingencies may crop up on account of rise in prices, business depression, strikes, lock-outs, fires and unexpected competition. It is needed over and above the regular working capital 

Temporary Working Capital

➢The temporary working capital is also called as variable working capital it usually fluctuates with the volume of business.

It may be sub-divided into:

(i) Seasonal(ii) Special working capital.

(i) Seasonal working capital:

It refers to liquid capital needed during the particular season. According to Gestenberg, “Beyond initial and regular working capital, most businesses will require at stated intervals a large amount of current assets to fill the demands of the seasonal busy periods”.During the season, the business enterprises have to push up purchase of raw materials (sugarcane by sugar mills, wool by woolen mills) and employ more people to convert them into finished goods and thus require large amount of working capital.

(ii) Special working capital:

It is that part of the variable capital which is needed for financing special operations such as the organisation of special campaigns for increasing sales through advertisement or other sale promotion activities for conducting research experiments or execution of special orders of Government that will have to be financed by additional working capital.The distinction between permanent and variable working capital is important in arranging the finance for an enterprise. Permanent working Capital should be raised in the same way as fixed capital is procured.

Components of working capital

Working capital is composed of various current assets and current liabilities, which are as follows:

➢ Current Assets➢ Current Liabilities

Current Assets:These assets are generally realized within a short period of time, i.e. within one year.

Current Liabilities:Current liabilities are those which are generally paid in the ordinary course of business within a short period of time, i.e. one year.

Current assets include:(a) Inventories or Stocks

(i) Raw materials(ii) Work in progress(iii) Consumable Stores(iv) Finished goods

(b) Sundry Debtors(c) Bills Receivable(d) Pre-payments(e) Short-term Investments(f) Accrued Income and(g) Cash and Bank Balances

Current liabilities include:(a) Sundry Creditors(b) Bills Payable(c) Accrued Expenses(d) Bank Overdrafts(e) Bank Loans (short-term)(f) Proposed Dividends(g) Short-term Loans(h) Tax Payments Due

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