Elaborate on the sources of finance available for enterprises:

 

 

Elaborate on the sources of finance available for enterprises:

Synopsis:

ü  Introduction

ü  Meaning and significant of sources of finance

ü  classify the various sources of finance available for enterprises

ü  conclusion

Introduction:

  This assignment provides an overview of the various sources from where funds can be procured for starting as also for running a business. It also discusses the advantages and limitations of various sources and points out the factors that determine the choice of a suitable source of business finance. It is important for any person who wants to start a business to know about the different sources from where money can be raised. It is also important to know the relative merits and demerits of different sources so that choice of an appropriate source can be made.

 

Meaning and significant of sources of finance:

 

Business is concerned with the production and distribution of goods and services for the satisfaction of needs of society. For carrying out various activities, business requires money.

Finance, therefore, is called the life blood of any business. The requirements of funds by business to carry out its various activities is called business finance. A business cannot function unless adequate funds are made available to it. The initial capital contributed by the entrepreneur is not always sufficient to take care of all financial requirements of the business. A business person, therefore, has to look for different other sources from where the need for funds can be met. A clear assessment of the financial needs and the identification of various sources of finance, therefore, is a significant aspect of running a business organisation.The need for funds arises from the stage when an entrepreneur makes a decision to start a business. Some funds are needed immediately say for the purchase of plant and machinery, furniture, and other fixed assets. Similarly, some funds are required for day-to-day operations, say to purchase raw materials, pay salaries to employees, etc. Also when the business expands, it needs funds. The financial needs of a business can be categorized as follows:

 

 

(a) Fixed capital requirements:

 In order to start business, funds are required to purchase fixed assets like land and building, plant and machinery, and furniture and fixtures. This is known as fixed capital requirements of the enterprise. The funds required in fixed assets remain invested in the business for a long period of time. Different business units need varying amount of fixed capital depending on various factors such as the nature of business, etc. A trading concern for example, may require small amount of fixed capital as compared to a manufacturing concern. Likewise, the need for fixed capital investment would be greater for a large enterprise, as compared to that of a small enterprise.

 

(b) Working Capital requirements:

The financial requirements of an enterprise do not end with the procurement of fixed assets. No matter how small or large a business is, it needs funds for its day-to-day operations. This is known as working capital of an enterprise, which is used for holding current assets such as stock of material, bills receivables and for meeting current expenses like salaries, wages, taxes, and rent.

The amount of working capital required varies from one business concern to another depending on various factors. A business unit selling goods on credit, or having a slow sales turnover, for example, would require more working capital as compared to a concern selling its goods and services on cash basis or having a speedier turnover. The requirement for fixed and working capital increases with the growth and expansion of business. At times additional funds are required for upgrading the technology employed so that the cost of production or operations can be reduced. Similarly, larger funds may be required for building higher inventories for the festive season or to meet current debts or expand the business or to shift to a new location. It is, therefore, important to evaluate the different sources from where funds can be raised.

 

Classifications of various sources of finance available for enterprises:

In case of proprietary and partnership concerns, the funds may be raised either from personal sources or borrowings from banks, friends etc. In case of company form of organization, the

Different sources of business finance which are available may be categorized as given in as shown in the table; the sources of funds can be categorized using different basis viz., on the basis of the period, source of generation and the ownership. A brief explanation of these classifications and the sources is provided as follows:

                                                         Classification of Sources of Fund

                                          

Sources of fund           classification

                                                                          

 

                                                    

                                                                                                                                                                                               

On the basis of period                          on the basis of ownership                          on the basis of sources of generation

                               

                                                                                                                                                          

                                                                                

Short term fund                  long term fund        owner’s funds                      borrowed fund

1) Trade credit                     1) equity shares      1) equity shares          1) loan from financial institution       

2) Factoring                           2) retained earnings 2) retain earring        2) loan from banks

3) Banks                              3) preference shares                                 3) public deposit

4) Commercial paper           4) debentures                                             4) commercial paper

                                            5) Loan from financial institution                 5) debentures

                                            6) Loan from banks

                         Medium term fund

                   1) Loan from banks                      internal sources                                      external sources

                   2) Public deposit                           1) equity share capital       1) loan from banks

                   3) Loan from financial institution    2) retain earnings            2) preference shares

                   4) Lease financing                                                                  3) public deposits

                                                                                                                  4) lease financing

                                                                                                                 5) Debenture

                                                                                                                 6) Commercial papers

                                                                                                                 7) Financial institution

                                                                                                                 8) Trading credit

                                                                                                                 9) Factoring

 

SOURCES OF FINANCE

                      A business can raise funds from various sources. Each of the sources has unique characteristics, which must be properly understood so that the best available source of raising funds can be identified. There is not a single best source of funds for all organizations. Depending on the situation, purpose, cost and associated risk, a choice may be made about the source to be used. For example, if a business wants to raise funds for meeting fixed capital requirements, long term funds may be required which can be raised in the form of owned funds or borrowed funds. Similarly, if the purpose is to meet the day-to-day requirements of business, the short term sources may be tapped. A brief description of various sources, along with their advantages and limitations is given below.

 

Retained Earnings

                   A company generally does not distribute all its earnings amongst the shareholders as dividends. A portion of the net earnings may be retained in the business for use in the future. This is known as retained earnings. It is a source of internal financing or self financing or ‘pouching back of profits’. The profit available for pouching back in an organization depends on many factors like net profits, dividend policy and age of the organization.

 

Trade Credit

                  Trade credit is the credit extended by one trader to another for the purchase of goods and services. Trade credit facilitates the purchase of supplies without immediate payment. Such credit appears in the records of the buyer of goods as ‘sundry creditors’ or ‘accounts payable’. Trade credit is commonly used by business organizations as a source of short-term financing. It is granted to those customers who have reasonable amount of financial standing and goodwill. The volume and period of credit extended depends on factors such as reputation of the purchasing firm, financial position of the seller, volume of purchases, past record of payment and degree of competition in the market. Terms of trade credit may vary from one industry to another and from one person to another. A firm may also offer different credit terms to different customers.

 

Factoring

Factoring is a financial service under which the ‘factor’ renders various services which includes:

 

(A) Discounting of bills (with or without recourse) and collection of the client’s debts. Under this, the receivables on account of sale of goods or services are sold to the factor at a certain discount. The factor becomes responsible for all credit control and debt collection from the buyer and provides protection against any bad debt losses to the firm. There are two methods of factoring—recourse and non-recourse. Under recourse factoring, the client is not protected against the risk of bad debts. On the other hand, the factor assumes the entire credit risk under non-recourse factoring i.e., full amount of invoice is paid to the client in the event of the debt becoming bad.

 

(b) Providing information about credit worthiness of prospective client’s etc., Factors hold large amounts of information about the trading histories of the firms. This can be valuable to those who are using factoring services and can thereby avoid doing business with customers having poor payment record. Factors may also offer relevant consultancy services in the areas of finance, marketing, etc. The factor charges fees for the services rendered. Factoring appeared on the Indian financial scene only in the early nineties as a result of RBI initiatives. The organizations that provides such services include SBI Factors and Commercial Services Ltd., Can bank Factors Ltd., Foremost Factors Ltd., State Bank of India, Canara Bank, Punjab National Bank, Allahabad Bank. In addition, many non-banking finance companies and other agencies provide factoring service.

                                                                                                                                                                   

Lease Financing

                 A lease is a contractual agreement whereby one party i.e., the owner of an asset grants the other party the right to use the asset in return for a periodic payment. In other words it is a renting of an asset for some specified period. The owner of the assets is called the ‘lesser’ while the party that uses the assets is known as the ‘lessee’. The lessee pays a fixed periodic amount called lease rental to the lesser for the use of the asset. The terms and conditions regulating the lease arrangements are given in the lease contract. At the end of the lease period, the asset goes back to the lesser. Lease finance provides an important means of modernization and diversification to the firm. Such type of financing is more prevalent in the acquisition of such assets as computers and electronic equipment which become obsolete quicker because of the fast changing technological developments. While making the leasing decision, the cost of leasing an asset must be compared with the cost of owning the same.     

 

Public Deposits

                   The deposits that are raised by organizations directly from the public are known as public deposits. Rates of interest offered on public deposits are usually higher than that offered on bank deposits. Any person who is interested in depositing money in an organization can do so by filling up a prescribed form. The organization in return issues a deposit receipt as acknowledgment of the debt. Public deposits can take care of both medium and short-term financial requirements of a business. The deposits are beneficial to both the depositor as well as to the organization. While the depositors get higher interest rate than that offered by banks, the cost of deposits to the company is less than the cost of borrowings from banks. Companies generally invite public deposits for a period up to three years. The acceptance of public deposits is regulated by the Reserve Bank of India.   

 

Commercial Paper (CP)

              Commercial Paper emerged as a source of short term finance in our country in the early nineties. Commercial paper is an unsecured promissory note issued by a firm to raise funds for a short period, varying from 90 days to 364 days. It is issued by one firm to other business firms, insurance companies, pension funds and banks. The amount raised by CP is generally very large. As the debt is totally unsecured, the firms having good credit rating can issue the CP. Its regulation comes under the purview of the Reserve Bank of India.     

 

 

Issue of Shares

                 The capital obtained by issue of shares is known as share capital. The capital of a company is divided into small units called shares. Each share has its nominal value. For example, a company can issue 1, 00,000 shares of Rs. 10 each for a total value of Rs. 10, 00,000. The person holding the share is known as shareholder. There are two types of shares normally issued by a company. These are equity shares and preference shares. The money raised by issue of equity shares is called equity share capital, while the money raised by issue of preference shares is called preference share capital.

 

(a) Equity Shares Equity shares is the most important source of raising long term capital by a company. Equity shares represent the ownership of a company and thus the capital raised by issue of such shares is known as ownership capital or owner’s funds. Equity share capital is a prerequisite to the creation of a company. Equity shareholders do not get a fixed dividend but are paid on the basis of earnings by the company. They are referred to as ‘residual owners’ since they receive what is left after all other claims on the company’s income and assets have been settled. They enjoy the reward as well as bear the risk of ownership. Their liability, however, is limited to the extent of capital contributed by them in the company. Further, through their right to vote, these shareholders have a right to participate in the management of the company.            

 

 

(b) Preference Shares the capital raised by issue of preference shares is called preference share capital. The preference shareholders enjoy a preferential position over equity shareholders in two ways:

(I) receiving a fixed rate of dividend, out of the net profits of the company, before any dividend is declared for equity shareholders .and

(ii) Receiving their capital after the claims of the company’s creditors have been settled, at the time of liquidation. In other words, as compared to the equity shareholders, the preference shareholders have a preferential claim over dividend and repayment of capital. Preference shares resemble debentures as they bear fixed rate of return. Also as the dividend is payable only at the discretion of the directors and only out of profit after tax, to that extent, these resemble equity shares. Thus, preference shares have some characteristics of both equity shares and debentures. Preference shareholders generally do not enjoy any voting rights. A company can issue different types of preference shares                        

 

 Debentures

            Debentures are an important instrument for raising long term debt capital. A company can raise funds through issue of debentures, which bear a fixed rate of interest. The debenture issued by a company is an acknowledgment that the company has borrowed a certain amount of money, which it promises to repay at a future date. Debenture holders are, therefore, termed as creditors of the company. Debenture holders are paid a fixed stated amount of interest at specified intervals say six months or one year. Public issue of debentures requires that the issue be rated by a credit rating agency like CRISIL (Credit Rating and Information Services of India Ltd.) on aspects like track record of the company, its profitability, debt servicing capacity, credit worthiness and the perceived risk of lending. A company can issue different types of debentures (see Box C and D). Issue of Zero Interest Debentures (ZID) which does not carry any explicit rate of interest has also become popular in recent years. The difference between the face value of the debenture and its purchase price is the return to the investor.          

 

Commercial Banks

            Commercial banks occupy a vital position as they provide funds for different purposes as well as for different time periods. Banks extend loans to firms of all sizes and in many ways, like, cash credits overdrafts, term loans, purchase/discounting of bills, and issue of letter of credit. The rate of interest charged by banks depends on various factors such as the characteristics of the firm and the level of interest rates in the economy. The loan is repaid either in lump sum or in installments. Bank credit is not a permanent source of funds. Though banks have started extending loans for longer periods, generally such loans are used for medium to short periods. The borrower is required to provide some security or create a charge on the assets of the firm before a loan is sanctioned by a commercial bank.

 

Financial Institutions

              The government has established a number of financial institutions all over the country to provide finance to business organizations. These institutions are established by the central as well as state governments. They provide both owned capital and loan capital for long and medium term requirements and supplement the traditional financial agencies like commercial banks. As these institutions aim at promoting the industrial development of a country, these are also called ‘development banks’. In addition to providing financial assistance, these institutions also conduct market surveys and provide technical assistance and managerial services to people who run the enterprises. This source of financing is considered suitable when large funds for longer duration are required for expansion, reorganization and modernization of an enterprise.

 

International Financing

             In addition to the sources discussed above, there are various avenues for organizations to raise funds internationally. With the opening up of an economy and the operations of the business organizations becoming global, Indian companies have an access to funds in global capital market. Various international sources from where funds may be generated include:

 

(I) Commercial Banks: Commercial banks all over the world extend foreign currency loans for business purposes. They are an important source of financing non-trade international operations. The types of loans and services provided by banks vary from country to country. For example,

Standard Chartered emerged as a major source of foreign currency loans to the Indian industry.

 

(ii) International Agencies and Development Banks: A number of international agencies and development banks have emerged over the years to finance international trade and business. These bodies provide long and medium term loans and grants to promote the development of economically backward areas in the world. These bodies were set up by the Governments of developed countries of the world at national, regional and international levels for funding various projects. The more notable among them include International Finance Corporation (IFC), EXIM Bank and Asian Development Bank.

 

(iii) International Capital Markets: Modern organizations including multinational companies depend upon sizeable borrowings in rupees as well as in foreign currency. Prominent financial instruments used for this purpose are:

           (a) Global Depository Receipts (GDR’s): The local currency shares of a company are delivered to the depository bank. The depository bank issues depository receipts against these shares. Such depository receipts denominated in US dollars are known as Global

Depository Receipts (GDR). GDR is a negotiable instrument and can be traded freely like any other security. In the Indian context, a GDR is an instrument issued abroad by an Indian company to raise funds in some foreign currency and is listed and traded on a foreign stock exchange. A holder of GDR can at any time convert it into the number of shares it represents. The holders of

GDRs do not carry any voting rights but only dividends and capital appreciation. Many Indian companies such as Infosys, Reliance, Wipro and ICICI have raised money through issue of GDRs.

 

        (b) American Depository Receipts (ADRs): The depository receipts issued by a company in the USA are known as American Depository Receipts. ADRs are bought and sold in American markets, like regular stocks. It is similar to a GDR except that it can be issued only to

American citizens and can be listed and traded on a stock exchange of USA.

 

         (c) Indian Depository Receipt (IDRs): An Indian Depository Receipt is a financial instrument denominated in Indian Rupees in the form of a Depository Receipt. It is created by an Indian Depository to enable a foreign company to raise funds from the Indian securities market. The IDR is a specific Indian version of the similar global depository receipts. The foreign company issuing IDR deposits shares to an Indian Depository (custodian of securities registered with the Securities and Exchange Board of India). In turn, the depository issues receipts to investors in India against these shares. The benefits of the underlying shares (like bonus, dividends, etc.) accrue to the IDR holders in India. According to SEBI guidelines, IDRs are issued to Indian residents in the same way as domestic shares are issued. The issuer company makes a public offer in India, and residents can bid in exactly the same format and method as they bid for Indian shares. ‘Standard Chartered PLC’ was the first company that issued Indian Depository Receipt in Indian securities market in June 2010.

   

         (d) Foreign Currency Convertible Bonds (FCCBs): Foreign currency convertible bonds are equity linked debt securities that are to be converted into equity or depository receipts after a specific period. Thus, a holder of FCCB has the option of either converting them into equity shares at a predetermined price or exchange rate, or retaining the bonds. The FCCB’s are issued in a foreign currency and carry a fixed interest rate which is lower than the rate of any other similar nonconvertible debt instrument. FCCB’s are listed and traded in foreign stock exchanges. FCCB’s are very similar to the convertible debentures issued in India.

 

 

 

 

 

 

Conclusion

         The financing of your business is the most fundamental aspect of its management. Get the financing right and you will have a healthy business, positive cash flows and ultimately a profitable enterprise. The financing can happen at any stage of a business’s development. On commencement of your enterprise you will need finance to start up and, later on, finance to expand. Finance can be obtained from many different sources. Some are more obvious and well-known than others. The following are just some of the means of finance that are open to you and with which we can help.