SOURCES OF FINANCE - Long term & Short Term

Briefly explain the long term and short term sources of finance?

Finance is the lifeblood of business concern, because it is interlinked with all activities performed by the business concern. In a human body, if blood circulation is  not proper, body function will stop. Similarly, if the finance not being properly arranged, the business system will stop. Arrangement of the required finance to each department  of business concern is highly a complex one and it needs careful decision. Financial requirement of the business differs from firm to firm and the nature of the requirements on the basis of terms or period of financial requirement; it may be long term and short- term financial requirements Long-term Financial Requirements or Fixed Capital Requirement Short-term Financial Requirements or Working Capital Requirement

LONG-TERM     FINANCIAL    REQUIREMENTS     OR     FIXED     CAPITAL REQUIREMENT

Long-term financial requirement means the finance needed to acquire land and building for business concern, purchase of plant and machinery and other fixed expenditure. Long term financial requirement is also called as fixed capital  requirements. Fixed capital is the capital, which is used to purchase the fixed assets of the firms such as land and building, furniture and fittings, plant and machinery, etc. Hence, it is also called a capital expenditure.

SHORT-TERM FINANCIAL REQUIREMENTS OR WORKING CAPITAL REQUIREMENT

Apart from the capital expenditure of the firms, the firms should need certain expenditure like procurement of raw materials, payment of wages, day-to-day expenditures, etc. This kind of expenditure is to meet with the help of short-term financial requirements which will meet the operational expenditure of the firms. Short- term financial requirements are popularly known as working capital.

SOURCES OF FINANCE

Sources of finance mean the ways for mobilizing various terms of finance to the industrial concern. Sources of finance state that, how the companies are mobilizing finance for their requirements. The companies belong to the existing or the new which need sum amount of finance to meet the long-term and short-term requirements such as purchasing of fixed assets, construction of office building, purchase of raw materials and day-to-day expenses. Sources of finance may be classified under various categories according to the following important heads:

According to Ownership

Owned Capital- Share Capital, Retained Earnings, Profit Surplus etc Borrowed Capital- Debentures, Bonds, Public Deposit, loans

According to source of Finance

External- Shares, Debentures, Public Deposit, loans etc. Internal- Retained Earnings, Profit Surplus ploughing back of profits, depreciation fund etc

ACCORDING TO PERIOD

I. LONG TERM SECURITY FINANCE

If the finance is mobilized through issue of securities such as shares and debenture, it is called as security finance. It is also called as corporate securities. This type of finance plays a major role in the field of deciding the capital structure of the company.

Characters of Security Finance Security finance consists of the following important characters:

1.   Long-term sources of finance.

2.   It is also called as corporate securities.

3.  Security finance includes both shares and debentures.

4.   It plays a major role in deciding the capital structure of the company.

5.  Repayment of finance is very limited.

6.   It is a major part of the company’s total capitalization.

Types of Security Finance Security finance may be divided into two major types:

1.    Ownership securities or capital stock.

2.    Creditor ship securities or debt capital.

OWNERSHIP SECURITIES The ownership securities also called as capital stock is commonly called as shares. Shares are the most Universal method of raising finance for the business concern. Ownership capital consists of the following types of securities.

●    Equity Shares

●    Preference Shares

●    No par stock

●    Deferred Shares

EQUITY SHARES

Equity Shares also known as ordinary shares, which means, other than  preference shares. Equity shareholders are the real owners of the company. They have a control over the management of the company. Equity shareholders are eligible to get dividend if the company earns profit. Equity share capital cannot be redeemed during the lifetime of the company. The liability of the equity shareholders is the value of unpaid value of shares.

FEATURES OF EQUITY SHARES Equity shares consist of the following important features:

1.   Maturity of the shares: Equity shares have permanent nature of capital, which has no maturity period. It cannot be redeemed during the lifetime of the company.

2.  Residual claim on income: Equity shareholders have the right to get income left after paying fixed rate of dividend to preference shareholder. The earnings or the income available to the shareholders is equal to the profit after tax minus preference dividend.

3.     Residual claims on assets: If the company wound up, the ordinary or equity shareholders have the right to get the claims on assets. These rights are only available to the equity shareholders.

4.   Right to control: Equity shareholders are the real owners of the company. Hence, they have power to control the management of the company and they have power to take any decision regarding the business operation.

5.   Voting rights: Equity shareholders have voting rights in the meeting of the company with the help of voting right power; they can change or remove any decision of the business concern. Equity shareholders only have voting rights in the company meeting and also they can nominate proxy to participate and vote in the meeting instead of the shareholder.

6.   Pre-emptive right: Equity shareholder pre-emptive rights. The pre-emptive right is the legal right of the existing shareholders. It is attested by the company in the first opportunity to purchase additional equity shares in proportion to their current holding capacity.

7.   Limited liability: Equity shareholders are having only limited liability to the value of shares they have purchased. If the shareholders are having fully paid up shares, they have no liability.

For example: If the shareholder purchased 100 shares with the face value of Rs. 10 each. He paid only Rs. 900. His liability is only Rs. 100. Total number of shares 100 Face value of shares Rs. 10 Total value of shares 100 × 10 = 1,000 Paid up value of shares  900 Unpaid value/liability 100

Liability of the shareholders is only unpaid value of the share (that is Rs. 100).

PREFERENCE SHARES

The parts of corporate securities are called as preference shares. It is the shares, which have preferential right to get dividend and get back the initial investment at the time of winding up of the company. Preference shareholders are eligible to get fixed rate of dividend and they do not have voting rights. It means a preference shareholder enjoys two rights over equity shareholders :(a) right to receive fixed rate of dividend and (b) right to return of capital. After settling the claims of outsiders, preference shareholders are the first to get their dividend and then the balance will go to the equity shareholders. However, the preference shareholders do not have any voting rights in the  annual general body meetings of the company. Preference shares may be classified into the following major types:

1.  Cumulative preference shares: Cumulative preference shares have right to claim dividends for those years which have no profits. If the company is unable to earn profit in any one or more years, C.P. Shares are unable to get any dividend but they have right to get the comparative dividend for the previous years if the company earned profit

2.  Non-cumulative preference shares: Non-cumulative preference shares have no right to enjoy the above benefits. They are eligible to get only dividend if the company earns profit during the years. Otherwise, they cannot claim any dividend.

3.  Redeemable preference shares: When, the preference shares have a fixed maturity period it becomes redeemable preference shares. It can be redeemable during the  lifetime of the company. The Company Act has provided certain restrictions on the return of the redeemable preference shares.

4.  Irredeemable Preference Shares: Irredeemable preference shares can be redeemed only when the company goes for liquidator. There is no fixed maturity period for such kind of preference shares.

5.  Participating Preference Shares Participating preference shareholders have right to participate extra profits after distributing the equity shareholders.

6.  Non-Participating Preference Shares Non-participating preference shareholders are not having any right to participate extra profits after distributing to the equity shareholders. Fixed rate of dividend is payable to the type of shareholders.

7.  Convertible Preference Shares Convertible preference shareholders have right to convert their holding into equity shares after a specific period. The articles of association must authorize the right of conversion.

8.  Non-convertible Preference Shares There shares, cannot be converted into equity shares from preference shares.

FEATURES OF PREFERENCE SHARES

1.    Maturity period: Normally preference shares have no fixed maturity period except in the case of redeemable preference shares. Preference shares can be redeemable only at the time of the company liquidation.

2.      Residual claims on income: Preferential shareholders have a residual claim on income. Fixed rate of dividend is payable to the preference shareholders.

3.       Residual claims on assets: The first preference is given to the preference shareholders at the time of liquidation. If any extra Assets are available that should be distributed to equity shareholder.

4.     Control of Management: Preference shareholder does not have any voting rights. Hence, they cannot have control over the management of the company.

DEFERRED SHARES

Deferred shares also called as founder shares because these shares were normally issued to founders. The shareholders have a preferential right to get dividend before the preference shares and equity shares. According to Companies Act 1956 no  public limited company or which is a subsidiary of a public company can issue deferred shares. These shares were issued to the founder at small denomination to control over the management by the virtue of their voting rights.

NO PAR SHARES

When the shares are having no face value, it is said to be no par shares. The company issues this kind of shares which is divided into a number of specific shares without any specific denomination. The value of shares can be measured by dividing the real net worth of the company with the total number of shares. Value of no. per share

=the realnetworth/Total no. Of shares

CREDITORSHIP SECURITIES Creditor ship Securities also known as debt finance which means the finance is mobilized from the creditors. Debenture and Bonds are the two major parts of the Creditors hip Securities.

DEBENTURES

Debenture is a document issued by the company. It is a certificate issued by the company under its seal acknowledging a debt. Debentures are the loans taken by the company. It is a certificate or letter issued by the company under its common seal acknowledging the receipt of loan. A debenture holder is the creditor of the company.  A

debenture holder is entitled to a fixed rate of interest on the debenture amount. Payment of interest on debenture is the first charge against profits. Apart from the loans from financial institutions, a company may raise loans through debentures. This is an additional source of long-term finance. The payment of interest and principal amounts  on these debentures is subject to the terms and conditions of issue of debentures.

According to the Companies Act 1956, “debenture includes debenture stock, bonds and any other securities of a company whether constituting a charge of the assets of the company or not.”

Types of Debentures it may be divided into the following major types:

1.   Unsecured debentures: Unsecured debentures are not given any security on assets of the company. It is also called simple or naked debentures. This type of debentures is traded as unsecured creditors at the time of winding up of the company.

2.   Secured debentures: Secured debentures are given security on assets of the company. It is also called as mortgaged debentures because these debentures are given against any mortgage of the assets of the company.

3.   Redeemable debentures: These debentures are to be redeemed on the expiry of a certain period. The interest is paid periodically and the initial investment is returned after the fixed maturity period.

4.   Irredeemable debentures: These kinds of debentures cannot be redeemable during the life time of the business concern.

5.    Convertible debentures: Convertible debentures are the debentures whose holders have the option to get them converted wholly or partly into shares. These debentures are usually converted into equity shares. Conversion of the debentures may be:

Non-convertible debentures Fully convertible debentures Partly convertible debentures

FEATURES OF DEBENTURES

1.  Maturity period: Debentures consist of long-term fixed maturity period. Normally, debentures consist of 10–20 years maturity period and are repayable with the principle investment at the end of the maturity period.

2.  Residual claims in income: Debenture holders are eligible to get fixed rate of interest at every end of the accounting period. Debenture holders have priority of claim in income of the company over equity and preference shareholders.

3.  Residual claims on asset: Debenture holders have priority of claims on Assets of the company over equity and preference shareholders. The Debenture holders may have

either specific change on the Assets or floating change of the assets of the company. Specific change of Debenture holders are treated as secured creditors and floating change of Debenture holders are treated as unsecured creditors.

4.  No voting rights: Debenture holders are considered as creditors of the company. Hence they have no voting rights. Debenture holders cannot have the control over the performance of the business concern.

5.  Fixed rate of interest: Debentures yield fixed rate of interest till the maturity period. Hence the business will not affect the yield of the debenture.

RETAINED EARNINGS

Retained earnings are another method of internal sources of finance. Actually is not a method of raising finance, but it is called as accumulation of profits by a company for its expansion and diversification activities. Retained earnings are called under different names such as; self finance, inter finance, and plugging back of profits. According to the Companies Act 1956 certain percentage, as prescribed by the central government (not exceeding 10%) of the net profits after tax of a financial year have to  be compulsorily transferred to reserve by a company before declaring dividends for the year. Under the retained earnings sources of finance, a part of the total profits is transferred to various reserves such as general reserve, replacement fund, reserve for repairs and renewals, reserve funds and secrete reserves, etc.

II.  MEDIUM-TERM FINANCE Medium-term finance refers to such sources of  finance where the repayment is normally over one year and less than three years. This is normally utilized to buy or lease motor vehicles, computer equipment, or machinery whose life is less than three years. The sources of medium term finance are as given below:

Bank Loans: -

Bank loans are extended at a fixed rate of interest. Repayment of the loan and interest are scheduled at the beginning and are usually directly debited to the current account of the borrower. These are secured loans.

Hire-Purchase: -

It is a facility to buy a fixed asset while paying the price over a long period of time. In other words, the possession of the asset can be taken by making a  down payment of a part of the price and the balance will be repaid with a fixed rate of interest in agreed number of installments. The buyer becomes the owner of the asset only on payment of the last installment. The seller is the owner of the asset till the last installment is paid. In case there is any default in payment, the seller can reserve  the right of collecting back the asset. Today, most of the consumer durables such as cars, refrigerators, TVs and so on, are sold on hire-purchase basis. It provides an opportunity to keep using the asset much before the full price is paid.

 Leasing or Renting: -

Where there is a need for fixed assets, the asset need not be purchases. It can be taken on lease or rent for specified number of years. The company who owns the asset is called lesser and the company which takes the asset on leas is called lessee. The agreement between the lesser and lessee is called a lease agreement. On the expiry of the lease agreement, the owner takes the asset back into his custody. Under lease agreement, ownership to the asset never passes. Only possession of the asset passes from lesser to the lessee. Lease is not a loan. But when the business wants a certain asset for a short/medium period, lease can significantly reduce the financial requirements of the business to buy the asset.

Venture Capital: -

This form of finance is available only for limited companies. Venture capital is normally provided in such projects where there is relatively a higher degree of risk. For such projects, finance through the conventional sources may not be available. Many banks offer such finance through their merchant banking divisions, or specialist banks which offer advice and financial assistance. The financial assistance may take the form  of loans and venture capital. In the case of viable or feasible projects, the merchant banks may participate in the equity also. In return, they expect one or two (depending up on the volume of funs pumped in) director positions on the board to exercise the control on the company matters. The funds, so provided by the venture capital, can be used for acquiring another company or launching a new product or financing expansion and growth.

III.  SHORT-TERM FINANCE

Commercial Paper (CP):

It is a new money market instrument introduced in India in recent times. CPs are issued usually in large denominations by the leading, nationally reputed, highly rated  and credit worthy, large manufacturing and finance companies in the public and private sector. The proceeds of the issue of commercial paper are used to finance current transactions and seasonal and interim needs for funds. Reliance Industries is one of the early companies which are issued Commercial Paper.

Bank Overdraft:

This is a special arrangement with the banker where the customer can draw  more than what he has in this savings/current account subject to a maximum limit. Interest is charged on a day-to-day basis on the actual amount overdrawn. This source is utilized to meet the temporary shortage of funds.

Trade Credit: -

This is a short-term credit facility extended by the creditors to the debtors. Normally, it is common for the traders to buy the material and other supplies from the suppliers on credit basis. After selling the stocks, the traders pay the cash and buy   fresh

stocks again on credit. Sometimes, the suppliers may insist on the buyer to sign a bill (bill of exchange). This bill is called bills payable.

Debt Factoring or Credit Factoring

Debt Factoring is the arrangement with factor where the trader agrees to sell its accounts receivable or debtors at discount to the specialized dealers called factors. In the case of Credit Factoring, the trader agrees to sell his accounts payables (at premium).

Advance from Customers:

- It is customary to collect full or part of the order amount from the customer in advance. Such advances are useful to meet the working capital needs. Short-term deposited from the customers, sister companies and outsiders

It is normal to find the supermarkets and trading organizations inviting deposits of six months to one year duration. As an incentive, such deposit holders may be given 5-10 precept discounts on the purchases. Internal funds:- Internal funds are generated by the firm itself by way of secret reserve, depreciation provisions, taxation provision, and retained profits and so on and these can be utilized to meet the urgencies.

A BRIEF SURVEY OF FINANCIAL INSTRUMENTS

Financial Instrument is a lawful agreement which involves some monetary value. Financial instruments have unique characteristics and structure. Financial instruments are in the form of cash instruments and derivative instruments. Financial instruments can be categorized into two types. They are:

PRIMARY SECURITIES:

Primary securities are those securities which are sold for the first time in financial markets. They are also termed as direct securities as they are issued directly to the savers by the ultimate investors of funds. Shares and debentures are good examples for primary securities as they are issued directly to the public. Shares: Share is a small part of capital of a company which is widely spread to raise long-term funds from the market. Usually, shares of a company are of two types. They are, equity shares and performance shares:

---- Equity Shares: Equity shares represent the ownership position in the company.

----Preference Shares: Preference shares are those share which enjoy some extra  benefits when compare to other types of shares.

-----Debentures: A company can obtain capital for long-term through issue of debentures. Debentures are similar to term loans in which borrower assure to  pay interest and principle amount at specified time period, usually, debentures are more adaptable than term loans as it involves many exceptional characteristics.

SECONDARY SECURITIES:

Secondary securities are termed as „indirect securities‟ as they are sold by intermediaries to the final savers. These financial intermediaries issue securities to the people and the money gathered is invested in companies. Unit Trust of India and mutual funds are the example of financial intermediaries. Commercial Papers: Commercial papers are issued by reputed and praise worthy companies, for short period of time.  They are issued in the form of unsecured promissory notes to raise funds for a period of 3 months to 1 year.

Certificates of Deposits: It is a letter of acknowledgement issued by bank to the person or company in return of fixed deposits made for specified period. Certificate of deposits are in the form of negotiable instruments which can be bought and sold in financial market.

Secured Premium Notes: Secured premium notes are form of long term debentures which are redeemable at a price higher than the face value, known as premium.

Non-convertible Debentures: Non-convertible debentures are those debentures which cannot be converted into equity shares. Investor gets the interest regularly and principle amount is paid only on maturity.

Zero Coupon Bonds: Zero coupon bonds have become famous in India a few years ago. These bonds do not yield any interest but they are sold to investor on heavy discount rate. Investor gets the profit from the difference of its purchase price and maturity value.

Zero Interest Fully Convertible Debentures Bonds: Zero interest bonds do not provide any interest but they are convertible into equity shares on specified period. They are introduced in India a few years ago.

Deep Discount Bonds: Deep discount bonds are those bonds which are sold by Issuer Company on heavy discount from its maturity value. But zero discount bonds do not yield any interest. IDBI was the first bank to introduce these bonds in India.