Sources of Finance – a brief

The two broad sources of finance available to a firm are: shareholders’ funds (equity funds) and loan funds (debt funds).

Equity capital represents ownership capital as equity shareholders collectively own the firm. Equity shareholders enjoy the rewards as well as bear the risk of ownership.

The rights of equity shareholders consist of: (1) the right to residual income, (2) the right to control, (3) the pre-emptive right to purchase additional equity shares issued by the firm, and (4) the residual claim over assets in the event of liquidation.

When a company is formed, it first issues equity shares to the promoters (founders) and also, in most cases, to a select group of investors. As the company grows, it may rely on the following methods of raising equity capital: initial public offering seasoned offering, rights issue, private placement and preferential allotment.

The first public offering of equity shares of a company, which is followed by a listing of its shares on the market, is called an initial public offering (IPO). A public issue by a listed company is called a seasoned offering. A rights issue involves selling securities in the primary market by issuing rights to the existing shareholders. Private placement and preferential allotment sale of securities to a limited number of sophisticated investors such as financial institutions, mutual funds, venture capital funds, banks and so on.

Preference capital represents a hybrid form of financing — it takes some characteristics of equity and some attributes of debentures.

The internal accruals of a firm consist of deprecation charges and retained earnings.

Terms loans represent a source of debt finance which is generally repayable in less than 10 years. They are employed to finance acquisition of fixed assets and working capital margin.

Financial institutions give rupee term loans as well as foreign currency term loans. Term loans represent secured borrowing. Usually assets, which are financed with the term loan, provide the prime security. Other assets of the firm may serve as collateral security. The principal amount of a terms loan is generally repayable over a period of 4 to 7 years after an initial grace period of 1 to 2 years. In order to protect their interest, financial institutions impose restrictive covenants on the borrowers.

Financial institutions appraise a project from the marketing technical, financial, economic and managerial angles.

For large firms debentures are a viable alternative to term loans. Debentures are instruments for raising debt finance Debentures often provide more flexibility than term loans and they offer greater choice with respect to maturity, interest rate, security, repayment and special features.

Thanks to the latitude enjoyed by companies, a variety of debt instruments like deep discount bonds, convertible debentures floating rate bonds, secured premium notes and indexed bonds have been employed.

Private placement of debentures has become very popular in India in recent years. The principal buyers of privately placed debentures are mutual funds financial institutions, insurance companies, Army Group insurance, Navy Group insurance, Air Force Group Insurance and so on.

Working capital advance by commercial banks represents the most important source of financing current assets. Working capital advance is provide by commercial banks in three primary ways: (1) cash credits /overdrafts, (2) loans and (3) purchase /discount of bills.

Apart from the principle sources like equity, internal accruals, terms loans, debentures, and working capital advance there are several other ways in which finance may be obtained. These include deferred credit, lease finance, hire purchase unsecured loans and deposits, special schemes of institutions. Subsidies, sales tax, deferments and exemptions, commercial paper, and factoring.

Many a times the suppliers of machinery offer deferred credit facility under which payment for the purchase of machinery is made over time. A lease represents a contractual arrangement whereby the lessor grants the lessee the right to use an asset in return for periodic lease rental payments. In a hire purchase arrangement the hiree (the counterpart of the lessor) purchase the asset and gives it on hire to the hirer (the counterpart of lesser). The hirer pays regular hire purchase installments over a specified period of time. When the hirer pays the last installment, the title of the asset is transferred from the hiree to the hirer. Unsecured loans are typically provided by the promoters. Deposits from public referred to as public deposits represent unsecured borrowing of one to three years (five years in the case of non-banking finance companies) duration. Financial institutions have designed special schemes like the bill rediscounting scheme of IDBI and the supplier’s line of credit of ICICI to serve the varied needs of industry. Governments may grant subsidies for certain kinds of projects, provide sales tax deferments and exemptions. Financial institutions provide short term loans to companies with good track record. Commercial paper represents short term unsecured promissory notes issued by firms which enjoy a fairly high credit rating. Factor is a financial institution which offers services relating to management and financing of debts arising from credit sales.