Sources of Finance:
Broadly, various sources of finance can be categorized as follows
Broadly, various sources of finance can be categorized as follows
Chapter 3- Sources of Finance
A Joint Stock Company may raise finance from many
sources. These sources are broadly classified into two categories:
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Long Term Sources
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Short Term Sources
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Equity Shares
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Commercial Banks
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Preference Shares
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Public Deposits
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Debentures
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Trade Credit
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Loans From Commercial Banks
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Customer Advance
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Loans From Financial Institutions
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Factoring
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Retained Earnings
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Installment Credit
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Inter-Corporate Finance
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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
3.
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 programmes 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.
The main features of Equity Shares are as
follows:
1. 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.
2. 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.
3. 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.
4. 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.
Advantages of Equity Shares
A.) From the company point of
view
1. 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.
2. 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.
3. 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.
4. 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.
5. 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.
B.)
From the shareholder point of view
1. Voting rights – Equity
shareholders have full voting rights and participate in the meetings of
shareholders. They elect directors and approve major policy changes.
2. 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.
3. 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.
5. Bonus shares and Right shares –
Bonus shares and Right shares are issued only to the equity shareholders.
5. 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.
Disadvantages of Equity Shares
A.)
From the company point of view
1. 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.
2. 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.
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.
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.
B.)
From the shareholders point of view
1. 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.
2. Uncertainty
of dividend – Dividend on equity shares is paid only out of
profits. In case, the profits are not sufficient, no dividend is paid.
3. 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.
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.
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 fixed rate of dividend is paid on preference shares.
2. The
preference shareholders have preference in getting the dividend. It is paid in
priority to equity share dividend.
3.
The preference share capital is returned in priority to equity share capital,
if the company is closed.
4.
Preference shareholders do not have voting rights and cannot take part in the
meetings of the shareholders.
5.
A company can issue different kinds of preference shares, like redeemable,
non-redeemable, commulative or non-commulative shares, etc.
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. 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.
3. 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.
4. 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.
5. 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.
6. Flexibility – A company can maintain
flexibility in its capital structure by issuing redeemable preference shares.
B.) From the point of view of the investors
(Preference shareholders)
1. 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.
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. Cummulative Dividend – In
case of cummulative preference shares, the dividend is carried forward and the
arrears are paid out of the future profits.
Disadvantages
of Preference Share
A.)
From the point of view of the company
1. Low appeal – Preference shares have
a very low appeal to the investors. A cautious investor prefers debentures than
preference shares.
2. Permanent burden –
There is a permanent burden on the company to pay dividend on cumulative
preference shares
3. More legal formalities – A
company has to follow a number of legal formalities when preference shares are
to be redeemed
4. Costly – The dividend on
preference shares cannot be treated as business expense, therefore, the company
has to pay higher rate of tax.
B.)
From the point of view of the investors
1. No voting rights – Preference shareholders cannot participate in
the meetings of the shareholders.
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. 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.
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.
CHARACTERSTICS:-
a)
Debentures represent borrowed fund.
b)
A fixed rate of interest is paid on debentures.
c)
Interest is payable every year irrespective whether
there are profits or not.
d)
Debentures generally carry no voting rights.
e)
Debentures generally involve a charge on the
assets of the company.
f)
Debentures are generally redeemable and repayable
after a fixed period of time.
KINDS OF DEBENUTES:- Debentures
are of the following types:-
1. Registered debentures: - Registered debentures are those which
are recoded 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.
2. 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.
3. 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 ,
·
Floating
Charge
When the charge is given on some specific assets,
it is known as fixed charge.
When the assets in general are give by way of
security, it is known as a floating charge.
4. 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.
5. 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.
6. 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.
7. 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.
8. Non-convertible
debentures: All
debentures are non-convertible unless there is an option of conversion into
equity shares.
ADVANTAGES OF ISSUING DEBENTURES
A) Advantages from the point
of view of Company:-
i) 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.
ii) 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.
iii) 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.
iv) 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.
v) 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:
i) Fixed and regular
return: The
debenture-holders and paid a fixed rate of return at regular interval
irrespective of profits.
ii) 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.
iii)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.
iv) 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:
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Shares
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Debentures
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1.
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2
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Yield( reward for investment)
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3.
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Nature of return
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4.
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Security
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5.
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Voting rights
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6.
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Redemption
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7.
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Order of repayment on winding up.
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8.
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Convertibility
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9.
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Tax benefit
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PUBLIC DEPOSITS
Non-banking companies are allowed to raise money from the public
including employees and shareholders. It is a kind of unsecured loan and the assets of the company are not required to be
mortgaged for accepting deposits from public. Public deposits can be accepted
for a period not less than six months,
but not exceeding three years at a time. Depositors get a fixed rate of interest which is usually
more than that available on bank deposits. At the same time, companies find it
cheaper than loans from banks and financial institutions.
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.
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
Ploughing 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 disproptionally.
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 Deposts 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 instalments 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 honour 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.
Disdvantages:
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.
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.
Disdvantages
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.
Instalment 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 instalments.
·
The seller/supplier charges interest on the
balance due and interest is included in the instalment. 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.
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 upto 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.
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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