27.07.

2007

Sources of Finance
By M.R.Krishna Murthy Cost accountant Partner, GNV AND ASSOCIATES, BANGALORE-560004
Every business entity needs funds for a variety of purposes, ex. replacement of obsolete machinery, expansion of existing activities, diversification into new products and penetrating into new markets. Working capital needs, payment of taxes, etc.There are two sources of finance available for business Internal and External. Of external sources, there are two types long term and short term. Conventionally, a sum of money which is received by a company with the understanding that it should be paid back within 12 months is considered to be a short term source. E.g. bank overdraft. Each source has a cost implication.

Internal Sources
There is only one source of internally generated finance and that is retained profits. Profits are made when all the costs of production, including management overheads, and everything, are subtracted from all the sales revenue. Once profits are made tax has to be paid on them. After the tax is deducted the business can decide to two either of two things with them: (1) distribute them to the owners or shareholders of the business, or (2) retain them for the future use of the business. It is these retained profits that provide the internal source of finance.

External Sources
This is finance that comes from outside the business. It involves the business owing money to outside individuals or institutions

Personal Savings
This mainly applies to sole traders and partnerships. Owners may use some of their own money as capital to invest in the business. For instance, a person may

-2be made redundant by a company that needs to reduce in size. They would receive redundancy payment (say under VRS) that they might use to start their own business. This is considered an external source as it is assumed that the money lent to the business will be paid back to the private individual in the future, possibly with an extra amount to compensate the individual for the help they gave. It can be a short or long term source of finance, depending upon the amount invested and the decision of the person using their savings.

Director's loans
The directors of the company, who are its shareholders, may make a loan into the company. This is not strictly share capital and will have to be paid back, but the loan is made on the understanding that it will only be paid back as and when the company can afford to do so, so really it is part and parcel of the process of obtaining share capital.

Other Forms
A large company can basically either (1) sell shares; or (2) borrow finance from banks and/or other financial institutions.

Loans from term Lending Institutions

Long term loans can be raised from various financial institutions such as State Financial Corporations, LIC of India, NSIC etc. The terms and conditions usually vary from institution to institution. Interest on term loan is eligible for tax exemption.

-3There are other ways in which externally generated finance can be obtained, but these are the two principle methods, and the fundamental choice facing the owners of the business. Shares are as the sound - a "share" in the business. When an investor buys a share he/she pays over a sum of money that does not every have to be given back by the business in return for a share in the ownership of the company. The obvious advantage of share capital is that it is "non-redeemable" - in other words, as a source of finance it is permanent and never has to be returned. The disadvantage is that in issuing shares the original owners of the business have to accept that other people will own part of their company, and the loss of control that this entails. Of course, if the other partners also bring in other expertise, the loss of control may be a bonus, but partnership is a tricky thing, and it is possible to choose the wrong partner, with woeful consequences. Bank loans and loans from financial institutions are injections of capital, but this capital does have to be paid back, and at interest. The company does not lose control of the direction of the business, but must generate revenues and profits sufficient to pay off the loan and the interest. If the interest rate is variable, the company could expose itself to changes in interest rates, with increasing costs and a resultant profit squeeze or loss.

Commercial Banks
India's financial system is predominantly bank-oriented, more like German and Japanese financial systems than American and British systems. We tend to consider two types of finance that banks offer to businesses, overdrafts and loans. Working Capital Loan: If a business spends more money than it has in its bank account, we say that it has become overdrawn. Businesses will often

have an arrangement with the bank whereby the bank will pay the extra money provided the business will pay them back in a fairly short period of time, with

-4interest. This is a short term source of finance and is useful for small amounts. It is often used for buying supplies / inputs. Commercial banks extend short term loans for working capital in the shape of overdraft, cash credits, bill discounting, etc. Such loans are usually secured by mortgage/hypothetication of fixed assets, immovable property of the business or its owners, stocks of raw material/finished goods and book debts, etc. Often a loan is sought from a bank for the specific purpose of purchasing a property, and the company pays the bank a mortgage. This is just a form of bank finance on which interest is charged, but the bank usually secures the loan against the property and this provides both them and the business with some degree of security in the case of business failure. Long Term A bank loan is a long term source of finance and will often be for much larger sums of money. A loan is useful for a business that is starting up or looking to grow. Loans are often used to buy fixed assets (see balance sheets) such as machinery and vehicles. A business will pay the bank back each month in installments and will also pay an interest charge. Interest - Banks are providing a service by lending money in the form of overdrafts and loans and banks will charge for this service (they want to make a profit too). When a business takes a loan, it will agree to pay it back over a period of years but it will also pay an extra charge. This charge, called interest, is a percentage of the value of the loan.

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The credit mechanism is controlled and the guidance on interest rate is given by the Reserve Bank of India and it varies from bank to bank giving them a level playing field. The higher the interest rate, the greater the percentage of the loan that the business must repay. In other words, if the Reserve Bank of India adjusts interest rates, a business with a loan will find it has to pay the bank more each month as it pays off its debt. Likewise, a fall in interest rates will mean that the business will have lower costs (and therefore more profit). The interest rate is an example of an external constraint - something outside the business' control that can seriously affect the business' performance.

Fixed Deposits from Public

The deposits are offered to public along with the shareholders and employees and are an importance source of finance. The interest rates vary from time period and RBI fixes the maximum rate of interest payable on these deposits. Only 85% of the interest on such deposits is eligible for income tax deduction. The major advantage of raising these deposits is that they are unsecured.

Factoring Services
Businesses are often owed money. If you supplied car parts to local garages, you would often deliver the products to the garages and receive payment within a few weeks. The garages would be paying by trade credit (see internal sources) and are in debt to you (they are your debtors - see balance sheet).

A business may have difficulty in collecting its debts from its customers but may need to get its hands on money very quickly. A special factoring company may -6offer to handle the debt collection process for a charge. The factoring company pays the business most of the value of the debt first and would then collect the money from the debtor. This is a short term source of finance.

Share Issue
An important source of finance for limited companies. A share issue involves a business selling new shares that entitle the shareholders to share in the control of the business. Each share gives the shareholder a vote on the direction of the company. This usually means that the shareholder can elect the board of directors of the company each year. If the shareholder doesn't like the way the directors are running the business, they can elect new directors. This is a good incentive to the directors to run the business well and make a profit which will be paid to the shareholders in the form of dividends. The more shares a person holds, the more control they have over a company. If one company wanted to take another company over, it could arrange to buy over 50% of that company's shares. This would give it a majority of control and, therefore, ownership. Issuing new shares can raise a lot of capital that can be used for expansion (buying more fixed assets, etc). It is a long term source of finance. If the total number of shares rises, the votes of existing shareholders will have slightly less significance and they will have less control. The business will also have to pay dividends on a larger number of shares. Types of equity providers and options available: Corporate partnering Venture capital funds

Corporate venture capitalist Initial Public Offering (IPO) -7Rights Issue to existing shareholder rs Bonus Issue

SEBI has now decided to introduce a fast track mechanism for issuing securities, which would allow listed companies to raise funds from the market in the least possible time. Under this mechanism, the lead managers can proceed with the issue of capital raising plans of companies listed on NSC and BSE after filing offer document. This will happen once the necessary amendments to the SEBI (Disclosure and Investor Protection) Guidelines are released in a short time. This new mechanism will benefit only those companies which are listed in NSC/BSE for at least three years.

Debentures
This is a form of long term loan that can be taken out by a public limited company for a large sum and it will be paid back over several years. Large sums usually are borrowed from specialist financial institutions, but are also open to investors.

Venture capital
Some individuals join together to provide finance for new businesses that are just starting-up. They look for promising businesses and invest in them, hoping that the businesses will grow and that they will make a profit. This is similar to issuing shares.

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Leasing and Hire Purchase

Leasing involves business renting equipment that it may use for several years or months but never own. It will have a contract with a company who may come in to repair and service the product. The deal may also involve the product being replaced with a new model every so often. Businesses often lease equipment such as photocopiers. Hire purchase involves paying for equipment in installments. The business will not own the item until all the payments have been made. It usually works out more expensive to buy an item on hire purchase than paying all at once but it does mean that the business doesn't have to spend a large amount of money at once Thank you,