Short term and long term sources of finance

Financial needs of the organization

1. Long term – for a period of 5 to 10 years. For acquiring fixed assets

2. Medium term – 1 to 5 years. Expenditure for publicity

3. Short term – 0 to 1 year. Known as working capital requirements. Investments in current assets like stock, debtors etc

Short term sources of fund

1. Trade credit2. Commercial banks3. Fixed deposits for a period of one year or less4. Advance received from customers5. Various short term provisions

Trade credit

Credit granted by the suppliers of goods for a period of 15 to 90 days.

It is one of the good source of fund because there is no extra cost up to the period.

Commercial banks

Bank advance meant for not only for earning profit but also for socio-economic development.

Banks usually, advances granted on the security of some tangible assets like shares, gold, etc.

Forms of bank advances

1. Loans – entire advance is disbursed as the transfer of current account of the borrower on the basis of security.

2. Overdraft – facility to withdraw excess of credit balance in their current a/c.

3. Clean overdraft – based on the personal security4. Cash credit – same as loan except interest is paid

on used amount

Intercorporate deposits

Companies can borrow funds from another co. who have surplus fund for a period of six months.

Interest depend upon the amount and time period.

Certificate of deposits - CD

A certificate of deposit is a document of title to a term deposit.

There is prescribed rate on such fund. Issuer is not required to encash before the

maturity date. But it is freely transferable.

Features of CD

1. It can be issued by banks and financial institutions

2. Denomination is rupees one lac or its multiplications

3. Maturity period is 7 days to one year4. Genarally issued at discount5. It is freely transferable6. It is issued in demat form.

Public deposits

A co. can accept deposits from public maximum upon 35% of its paid up capital and reserve.

Period is 6 months to 3 years

Commercial Paper - CP

CP was introduced in india in 1990. It is an unsecured promisory note issued by

the co. who is financially sound and a listed co. for a period of 91 to 180 days.

It is generally issued at discount

Features of CP

The tangible networth of issuing co. should be less than rupees four crore

It is usually issued in multiples of Rs.5 lac. It is in the form of unsecured promisory note Minimum credit rating is required from CRISIL Its maturity is less than one year

Factoring

It is a financial service rendered by a factor wherein a business organization sells its accounts receivables to a factoring firm and gets cash from the factor, and the factor assumes responsibility of collecting dues from the concerned parties.

Types of factoring

1. Recourse factoring – any loss of bad debts will be borne by the business firm.

2. Non-recourse factoring – loss of bad debt will be met by factor.

3. Domestic factoring – if factoring is for domestic sales

4. Export factoring – if factor’s bank is situated in exporter’s country

Accruals

Expenses incurred but not paid

Income received in advance

Long Term Sources

Equity Shares Preference Shares Retaines earnings Debentures or bonds Loans form banks and financial institutions Venture capital financing Lease financing

Equity shares

Which are not preference shares Also called ordinary shares and holders are

real owners of the company.

“A share is a share in the share capital of the co.”

It can be issued at discount, premium or at face value.

Features

No claim on income No claim on assets Right to control Voting right Pre-emptive right Limited liability Transfer of shares

Advantages

Source of fixed capital No obligation for repayment No charge on assets Small nominal value such as Rs.10 Ideal for adventurous investors Voting power Right to new shares

Disadvantages

High risk Due to pre-emptive right management of the

co. may be concentrated in few hands No trading on equity

Preferance Shares

Enjoys preferential rights over equity shares in - payment of dividend and

- repayment of capital

Considered as hybrid security

Features

Senior security compared to equity shares Dividend is not tax deductable Fixed return No voting right No charge on assets Flexible – redeemable and irredeemable Sinking fund provision can be used

Types

Cummulative and non cummulative Participating and non participating Redeemable and irredeemable Convertable and non convertable

Advantages

Appeal to cautious investors – who seek reasonable safety and return

No obligation for dividend No interference in management No charge on assets Flexibility Variety

Disadvantages

Fixed obligation Limited appeal – not attractive to those who

wants higher return Low return No voting rights Chances of redumption

Debentures

A debenture is a certificate or document issued by a company under its seal as an acknowledgement of debt.

Repayment is at winding up or maturity. Reward is known as interest at fixed rate.

Features

Debentures represents borrowed capital Interest on debentures is payable on a fixed rate Interest on debentures is an obligation to the co. Debenture holders are creditors to the company Debenture holders have no voting rights Debentures may involve a charge on assets of

the co. flexibility

Types of debentures

Naked or simple and secured or mortgaged Redeemable and irredeemable Convertable and non convertable Registered and bearer debentures First and second debentures

Advantages

No voting rights Fixed interest Debenture interest is an expense to the co. Can be redeemed Trading on equity is possible

Disadvantages

Interest is an obligation to the company Creates a charge on company’s assets Common people can not buy debentures as

they are of high denominations

Shares v/s debentures

Shares part of owned capital return is dividend variable rate of retrn voting rights, owners and control over mgt. can not redeem no priority at winding up

Debentures part of borrowed capital return is interest fixed rate of return no voting rights, creditors and no control over mgt. can redeem priority over equity shares

Rtained earnings

All profits are not distributed to share holders as dividend. A part of profit would be reinvested in the business for growth and expansion.

The process of retaining profits year after year and their utilization in the business is called ploughing back of profit.

It is economical method of financing – no cost

Necessity

For replacing old assets For growth and expansion For redemtion of loans and debentures For contributing towards fixed as well as

working capital

Factors influencing ploughing back of profit

Earning capacity Desire and type of shareholders Future financial requirements Dividend policy – distribution or reinvest Taxation rate – available after tax

Venture capital

It is often used for growth and expansion of new and young enterprises.

Generally considered as high risky capital Venture capitalist will involve in the

management of the enterprise. They generally support to proven

technologies.

Features

Equity participation Long term investment Participation in management

process of venture financing

1. Deal origination – it is an active search for financiers

2. Screening – initial evaluation of all available venture capitalist

3. Risk analysis 4. Deal structuring – if both the parties are satisfied

they negotiate the terms of investment5. Post investment activites – venture capitalist can

act as an owner

Conditions of venture capital

According to Govt. of India1. Total investment should not exceed Rs.100

millions 2. New companies which incorporate some

significant improvement over the existing one’s in India

3. Should have qualified professionals

Term loans

A term loan is granted on the basis of a formal agreement between the borrower and the lending institution on the basis of an asset as a security for a fixed period of time.

In india commercial banks and specialized financial institutions like IDBI, ICICI, IFC, etc are providing term loans.

Conditions of term loan lending

An asset as a security Minimum working capital There will not be any additional debt Management should be effective

Lease financing

A lease is a contract between a lessor ie owner of the asset and the lessee, the user of the asset.

Owner gives the right to use the asset over an agreed period of time for a consideration called lease rental.

Lessor is the legal owner and he can claim the depreciation.

Types of lease

Operating lease – short term cancellable lease are called operating lease. Lessor is the responsible person for insurance and maintenance.

Financial lease – long term non-cancellable lease is called financial lease. It is for the whole life period of the asset. It will amortize the value of the asset and therefore it is called capital or full pay out lease.

Types of financial lease

1. Sale and lease back – the lessee sell an existing asset to lessor and take back by lease agreement.

2. Leveraged lease – three parties involved – lessor, lessee and a financier. Lessor meet 25% of the cost of asset and balance by the financier.

3. Cross-boarder lease – also known as international lease. Lessor and lessee situated in two different countries. If the lessor, lessee and manufacturer of asset are situated in three countries, it is called foreign to foreign lease.

Advantages of lease financing

1. Leasing provides 100% financing

Lessee can avoid the payment for acquiring asset and even if he has no suffient fund he can acquire asset by paying lease rental. He can use the fund for some other purposes.

2. Leasing improves performance

Lessee has to pay lease rental for the asset which did not appeared in the balance sheet. Naturally the performance of the lessee will be improved.

3. Leasing avoid cost of screening

For a long term investment sreening of all alternatives is an unavoidable part. But in leasing it is the duty of the lessor and therefore there is no such cost.

4. Convenience and flexibility

It is very cenvenient for lessee because lessor will undertake all the requirements of the asset.

5. Maintenance and specialised service

In leasing lessor will maintain the assets with specialised services.

Limitations of leasing

1. Costly option

Leasing company is a financial intermediary and he will charge heavy interest for lease financing.

2. Loss of tax

Lessee can not claim depreciation in leasing because he is not the actual owner.

3. No ownership

Leasing does not provide the advantages of ownership to the user.

4. Loss of residual value

The leased asset has to be returned to the lessor at the end of the lease period.

5. Chances of double sales tax

Depending on the prevailing sales tax laws in various states, there are possibilities of double sales tax, once at the time of sale and again when the asset is leased out.

Merger and acquisition

When two or more companies combined into one co. or one or more companies may merge with another existing co.

Two forms: Merger through absorption – combination of two or more

companies into an existing co. Except one all others will lose their identity.

Merger through consolidation – combination of two or more companies into a new co. All companies legally dissolved and a new entity is created.

Different forms

1. Acquisition – acquiring assets and liabilities or ownership or management by another co. without any combination.

2. Take over – obtaining control over mgt. of a co. by another co.

3. Horizontal merger – combination of two or firms in similar type of production.

4. Vertical merger – two or more companies involved in different stages of production.

Forward merger – combines with customers Backward merger – combines with suppliers5. Conglomerate merger – combination of firms engaged in

unrelated lines of business activity.

Motives or benefits of merger

Limit competition Utilise under-utilised market power Overcome the problem of slow growth and

profitability Displace existing management Create an image of strategic opportunism

Dangers of merger

Elimination of healthy competition Concentration of economic power –

monopolistic condition Adverse effect on national economy –

through monopoly and elimination of competition.

Buy outs

Popularly known as LBO – Leveraged Buy Outs It is an acquisition of a company in which the acquisition

is substantially financed through debt. A debt typically forms 70-90% of the purchase price.

After debt around 70-90% of total purchase price, financiers are forced to the co. owners to hand over the co. to them.

When the managers buy their co. from its owners employing debt is called Management Buy-Out.

Debt-Equity Swap

Swaps are exchange of future stream of cash flows.

A debt-equity swap is a transaction in which a corporation exchanges existing bonds (debt) for newly issued stock (equity). It is a refinancing deal in which a debt holder gets an equity position in exchange for cancellation of the debt.

The cash flows are called ‘legs’.

Financial structure

Financial structure means the entire liabilities side of the balance sheet.

It is the composition of a specified percentage of short-term debt, long-term debt and shareholder’s funds.