SOURCES OF BUINESS FINANCE

What is Business Finance? What are the financial needs of a business ? Concept of Finance What is Finance? What is Business Finance? What are the financial needs of a business ?

Factors Affecting Fixed Capital Requirements Nature of business Scale of business Expansion of business

Factors Affecting Working Capital Requirements Rate of stock turnover Credit policy Seasonal Business Nature of business

Classification of Sources of Business Finance Period Ownership Generation Long Term Owner’s Funds Internal Medium Term Borrowed Funds External Short Term

Internal Sources of Finance- Owner’s Funds Retained Earnings – Self Financing Features: Undistributed profits Depends on net profits, dividend policy and duration of business No additional burden

Retained Earnings Merits Demerits Dependable & Permanent Dissatisfaction amongst the shareholders No additional cost Fall in market price of shares No burden Uncertain source of fund Operational freedom & flexibility Opportunity cost is ignored Control Issue of bonus shares leading to overcapitalization

Internal Sources of Finance- Owner’s Funds 2. Issue of Shares: Total capital is divided into small units called shares The smallest unit is called par value or face value of shares Money raised through issue of shares is called capital Individual investing in the company by way of purchasing shares are called shareholders Types of shares issues: Equity & Preference

Equity Shares Features: Ownership capital – owners of the company Permanent source of finance Decision makers Residual owners Limited liability Fluctuating returns

Equity Shares Merits Demerits Permanent source of finance Expensive method of raising finance No burden on the company Higher returns to be paid Control over the company Dilution of control Higher Returns No certainty of return No charge on assets of the company No security of repayment of invested amount Increases the creditworthiness of the company Selling of shares may affect the creditworthiness of the company

Preference Shares Fixed rate of return Preferential priority with repect to payment of dividend or repayment of capital No voting rights Creditors of the company No charge on assets of the company

Types of preference shares Cumulative & Non Cumulative Convertible and Non Convertible Redeemable and Irredeemable Participating and non participating

Preference Shares Merits Demerits Preferential payment of dividend Rate of dividend is fixed No dilution of control No voting rights Income is steady and safe Restricts the investor from enjoying higher profits No charge on assets No security of repayment of investment Lower cost of capital No tax benefits Preferred for cautious investors Not attractive for investors willing to take risk Preferential rights on repayment of investment Dilute the claims of equity shareholders

Difference between Preference Share & Equity Shares Returns on capital Repayment of capital Voting rights Risk in investments Suitability control

EXTERNAL SOURCES OF FINANCE Debentures: Long term borrowed funds Document or a certificate issued under a common seal of a company as an acknowledgement of debt to the holder in accordance to the given terms and conditions. Long term sources of funds Rate of interest and time period Secured loans Creditors of the company Company planning to issue debentures to general public must get the company rated by CRISIL(Credit Rating & Information Services of India Ltd)

Types of Debentures Convertible Zero Interest Debentures Convertible and Non Convertible Debentures Secured & Unsecured Debentures Registered & Bearer Debentures First & Second Debentures

EXTERNAL SOURCES OF FINANCE Debentures Merits: It can be issued for a specific period according to the need of the company Fixed rate of return Control Safe for the investors Mostly secured Tax liability reduces Repayment of investment – enjoy preferential rights

Debentures Demerits: Process of raising finance long, complex and expensive (CRISIL) Financial burden in the years of non performance No voting rights Fixed returns Reduces the company’s capacity to borrow funds Not attractive for investors who are willing to take risk to earn higher returns Debentures need to be repaid after a fixed period of time

External Sources of Finance Trade Credit It is the credit extended to business by its suppliers. It is the facility to purchase inventories or services without making immediate payment. Credit is extended by suppliers Purchase on credit & pay within the stipulated period of time Reduces the need for working capital Short term source of finance It depends on the creditworthiness of the firm Does not involve any payment of interest

External Sources of Finance Merits of Trade Credit: Convenient & Continuous Does not involve any formalities Increases sales Enables the enterprise to maintain high stock levels No additional cost of raising finance No charge on the assets of the firm

External Sources of Finance Limitations of Trade Credit: High Stock Volumes - Over Trading Value of funds generated is limited Increase in the price of the goods

EXTERNAL SOURCES OF FINANCE 8. Commercial Banks: Loans on interest depending on the nature of loan Medium and short term loans against security Loans in the form of overdraft, term loans, cash credit, factoring etc

Commercial Banks Merits: Financial assistance as and when required Keeps the business information confidential Simple and fast Most flexible source of finance

Commercial Banks Demerits: Extension or renewal is uncertain Collateral security and sometimes personal security from the owner Sometimes makes the procedure lengthy and complicated Bank may impose many kinds of restrictions like sale of mortgaged assets, withdrawal of money of money by owner without bank permission etc Suitable for small and medium business only

EXTERNAL SOURCES OF FINANCE 9. Financial Institutions: Government has established many financial institutions at both centre and state levels They provide both long and medium term finance in the form of owned and borrowed capital They support business with technical and managerial assistance as well The main aim is to provide sufficient funds to support the industrial development of the country Thus they are also called developing banks Suitable for expansion, development, reorganisation

Financial Institutions Merits: Provide finance for long term period Reduces the burden of the enterprises Business can get financial, technical, marketing and consultancy services under one roof Financial institutions are able to provide finance even during depression periods

Financial Institutions Demerits: Procedure – rigid, time consuming and expensive Restrictions on companies regarding the payment of dividends They may have their nominees on the BOD of the borrowing company thereby restricting the powers of the company

Inter Corporate Deposits ICDs are unsecured short term deposits made by one company with another company. These are unsecured loans with high risk factors Interest rate on ICD depends on the credit rating of the corporate Interest rate is higher than the rate offered by the Bank

Merits of ICD Lender company can use surplus effectively They are easily procured Brokers maintain the secrecy of lenders and borrowers

Demerits Of ICD Company can not lend more than 10% of its net worth to a single company Company cannot lend beyond 30% of its net worth in total Borrowed funds cannot exceed 50% of net owner’s funds Market of ICD is not properly structured

Public Deposits PD are the source of finance where the funds are raised from shareholders, employees or general public Higher rate of interest than the rate offered by the bank Regulated by the RBI Period of finance – 6 months to 3 years They need not be backed by any charge against assets PD cannot be 25% of share capital or reserves

Merits The process of raising funds is simple Higher rate of interest Cheaper source of finance No mortgage of assets Control retained Interest paid on PD is regarded as expenses

Demerits Not easy for new companies Not reliable source of finance Attracts only cautious investors Not suitable for long period Complex procedure Amount is limited only to the 25% of share capital

Financial Institutions 3. International Capital Markets: The most common financial instruments used to meet the need of borrowing in dual currency are: Global depository Receipts (GDR’s) GDR’s are the depository receipts issued by the Depository Bank against the receipt of local currency shares of a company It is a negotiable instrument issued in US Dollars It can be traded freely like any other security A company issues GDR to raise finance in foreign currency It is listed and traded on a foreign stock exchange GDR represents a specific no. of shares and the holder of GDR can convert GDR into shares any time GDR’s enjoy dividend and capital appreciation but do not carry any voting rights Examples: Infosys, Reliance, Wipro, ICICI

Financial Institutions B) American Depository Receipts (ADR’s): ADR’s are issued by a non US company to an American Citizen. ADR’s are listed and traded on USA stock exchange only A non US business enterprise issues ADR to an American citizen and then funds can be raised by selling the ADR’s at the US stock exchange

Financial Institutions c) Indian Depository Receipts (IDR’s) It is a financial instrument denominated in Indian rupees in the form of a depository receipt created by a Indian Depository against the underlying equity of issuing company It enables the foreign companies to raise funds from the Indian securities market The custodian of securities is registered with the SEBI The foreign company IDRs deposit shares to an Indian depository and the depository issues receipts to investors in India against the shares deposited The size of an IDR cannot be less than Rs 50 crores

Financial Institutions d) Foreign Currency Convertible Bonds (FCCB’s) FCCBs are the debt securities issued in foreign currency with a fixed rate of interest They have the option of being converted into equity or depository receipts after a specific period of time at a predetermined price or exchange rate FCCBs are listed and traded in foreign stock exchange

Factors Affecting the Choice of the Source of Funds Cost Financial Strength & Stability of Operations Form of Organisation and Legal Status Purpose and Time Period Risk Profile Control Effect on Credit Worthiness Flexibility and Ease Tax Benefits

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