12 Sources of Finance

M. V. Subha

Every organization makes a plan to invest in long term assets. There are certain Assets which have long life and need to be financed with long term sources of finance. There are many sources of long term finance. We will discuss each one of them in detail.

1. Retained earnings

Companies retain a portion of their earnings and money accumulated through depreciation charges for future use. Whenever the company wants to replace its existing machinery or assets, it uses these funds. This forms the internal source of financing for the firm and is readily available to the firm. This also becomes the most reliable and easily available long term sources of funds for the company.

Features

The important feature of retained earnings is that

It is readily available to the firm.
There is no cost involved in raising of this capital unlike other source of finance which incurs floatation costs.
It does not alter the status quo of control in the firm. There is no dilution in the shareholding pattern of the firm due to this source of financing.
However, there is a limit to the amount of capital that can be raised through Retained earnings.
Since this is the dividend forgone by the shareholders, it entails high opportunity cost.
Therefore, this becomes a costly source of finance and therefore must be carefully utilized by the firm.

Retained earnings have both positive as well as negative features from the view of the company and the shareholders. Hence the same may be used by the firm judicially.

2. Equity Share Capital

This represents the ownership capital of the firm. Firms issue equity shares in order to raise long term capital fro the company. The shareholders of the company become the owners of the capital to the tune of the percentage of their shareholding. They share the reward and risk associated with the ownership of company’s securities. They are also referred to as ordinary shares.

Types:

The maximum amount of equity share capital which the company can raise from the ordinary shareholders is called Authorized capital. Issued capital refers to the portion of the Authorized capital issued to the shareholders Subscribed capital is that portion of the issued capital which has been subscribed by the investors.The amount that has been paid up by the shareholders is called as the Paid up capital.

The price that is indicated in the share certificate is called as the face value of the share. The rate at which it is issued to the public is called as the issue price. If it is issued at a price higher than the face value, it is said to be issued at a premium and in case if it is issued at a price lesser than the face value it is termed as Discount price. The book value of the shares represents the paid up capital plus reserves and surplus (net worth) divided by the total number of outstanding shares. The price at which shares are sold in the market refers to the Market value.

Features of Equity shares

1.Since Equity share holders are owners of the firm, they have a residual claim on the income of the company. They receive a portion of net profits after claiming for all Operating and financial expenses, taxes etc. This is issued as Dividend which is the earnings available to shareholders divided by the number o outstanding shareholders of the company.

2.The equity shareholders have a residual claim on the assets of the company after taking care of the creditors and other types of shareholders like preference shareholders during the liquidation of the company.

3. The equity shareholders are owners to the company and therefore have control over the management of the company. They approve the Board of Directors of the firm to take care and manage the day to day operations of the company. Every share is entitled to a voting right which is exercised by the shareholders of the company. Whenever, additional shares are issued by the company, the existing shareholders are given the first preference for purchase since they might want to maintain their percentage of shareholdings. (This is called as Preemptive right).

4. The shareholders are owners to the firm to the tune of percentage of shareholding they own which is the concept of limited liability.

Global Depository Receipts (GDR)

This represents an instrument issued in a foreign country and is listed in a foreign stock exchange. It does not have voting rights till it is converted into shares. Once the Global Depository Receipt are converted into ordinary shares, voting rights get restored to those shares.

Advantages

a. It is a permanent long term source of finance.

b. There is no legal obligation to distribute profits by ways of dividends to the shareholders. Company’s need to pay dividend only when it makes profits.

c. It helps to improve the creditworthiness of the firm. The capital base gives a strong financial structure to the firm and therefore, other financial institutions and vendors prefer to do business with these firms.

Disadvantages

The equity share financing represents high cost of finance because shareholders bear the risk of the entire enterprise as owners of the company. They have a residual claim on the income and therefore they expect high return for the higher level of risk undertaken by them. Therefore it is one of the costliest sources of long term finance available to the firm.
It is not easy to raise capital through the issue of equity shares. It involves high cost by way of brokerage to be paid to Underwriters, bankers, brokers etc. The floating cost that is the cost of raising equity capital is high. So companies need to bear this cost while opting for this source of financing.
Issue of equity shares creates an increase in the number of shareholders. This causes a dilution in the ownership of the firm.
The company’s performance has an impact on the market value of the shares. The market value increases or decreases in accordance with the performance of the firm.
Since there is no legal obligation to pay dividends every year, the shareholders cannot claim dividend as a matter of right. However, continuous non-payment or irregular declaration of dividend will affect the shareholder sentiments.

3. PREFERENCE SHARES

This is a unique form of financing which combines certain features of Equity as well as Debentures and therefore termed as an hybrid security. Preference Shares carries a fixed percentage of capital and it is termed as Preference Dividend which is to be paid to the preference share holders. After the Debenture holders, it is the preference share holders who have a claim on the earnings and assets of the company. The preference shares do not enjoy voting rights as in the case of ordinary share holders. They cannot make a claim on the other income of the firm over and above the Preference Dividend.

Features

When a company faces a situation of liquidation, the Preference Shareholders have a first claim on the earnings/assets to the tune of the amount due to them, ahead of the equity shareholders.
In case the company is not able to pay the preference dividend in the current year it can be postponed for a maximum period of two years. However, preference dividend will have to be paid cumulatively in the subsequent year.
Preference shares are issued at a value mentioned in the share certificate which is called the face value, with a fixed Preference dividend and has a Maturity Date. The preference shares can be redeemed at its face value on maturity.
The percentage of preference dividend mentioned in the preference share certificate is fixed and does not change till its maturity period.
In some cases preference shares are issued with convertibility features that permits the preference shares to be converted into equity shares at a pre-determined price on a future date. This option is voluntary and if the preference share holders are willing to exercise the convertibility feature, they can use them to convert into fixed number of equity shares on the date mentioned in the certificate.

Advantages

The preference dividend which is constant and it is an advantage to both the shareholders and the company as the financial commitments are known to both the parties well in advance and does not alter.

The option to skip payment of Preference dividend for a year in case of necessity is an advantage to the company.

Disadvantages

The income on preference share is limited to the Preference dividend to be paid and there is no provision for extra claim to be made by the preference share holders.

It is to be noted that generally Preference Dividend rate is quoted at a higher percentage and therefore is a costly source of financing available to the firm.

Preference shareholders are not eligible for any voting rights or participating right as in the case of equity share holders.

4. DEBENTURES/BONDS

Debentures or Bonds represent the creditorship securities of the firm and the holders of Debenture certificates are referred to as the creditors to the firm. Debentures represent short term debt borrowings of the firm and Bonds represent long term debt borrowings. A debenture certificate represents a promise to pay interest and repay Principal at a stipulated period (Maturity Date). Here, a fixed percentage of the principal amount (Face value of the Debenture certificate) is paid as interest on the borrowed capital (Principal/Face Value).

Features

When a company wants to raise debt capital through the issue of debentures, it appoints a trustee through a trust deed which is referred as Bond Indenture. It is a legal document between the issuing company and the trustee and specifies the legal covenants of the issue and the terms and conditions to be followed.
A percentage of the Principal is paid as Interest and is mentioned in the Debenture or Bond Certificate. The interest may be agreed to be paid annually, quarterly or half yearly.
Every debenture has a maturity date and it indicates the time at which the debentures can be redeemed at par value.
The assets of the company or sometimes a particular asset as mentioned in the Bond indenture represents the security of the debentures.
Some debentures come with convertibility features to convert the debenture into a fixed number of equity shares at a fixed pre-determined price, on a latter date. In case the debenture holders want to exercise the option, they may convert the debentures into equity shares. These are called as convertible debentures.
The debenture issues usually get themselves Credit Rated using major Credit rating agencies to access their credit worthiness. The same rating is mentioned in the Debenture or Bond Certificate.The Debenture holders have a first claim over the income or assets of the company in case of liquidation of the company.

Advantages

It is the cheapest source of long term financing option available to the company.
Since it comes with no voting rights, issue of debentures does not affect the shareholding pattern of the firm and there is no dilution in control.

Disadvantages

There is a legal claim on interest/income and therefore increases the financial risk complexion of the firm. This has a bearing on the Debt Equity ratio of the firm.
There is no participation in the working of the company due to lack of voting rights

5. Term Loans

Another important source of financing capital is procuring short term or medium term loans from Banks and financial institutions. This loan is usually taken for financing new projects and therefore called as Project finance.

Features

These loans are for a fixed tenure and therefore come with a maturity date (3-5, 5-10 years etc).
Interest are usually negotiated and fixed by financial institutions and the borrowers.
Term loans are secured and usually present and future assets of the company are given as security.
The Repayment of term loans are made by paying yearly interest and portion of principal every year. The calculation of Interest and Principal is made through an amortization schedule.

Advantages

a. It is an easy source of financing available to the company

b. It is also representing a low cost financing option to the firm.

Disadvantages

a.These are loans and therefore increase the Debt component of the firm. It increases the financial risk of the firm.

b. There is a legal obligation on part of the firm to pay the interest every year.

6. Convertible Debentures

The convertible debentures give the debenture holders the option to convert the debentures into ordinary shares on a future date at a predetermined price. The conversion price, the conversion ratio, conversion date etc. are mentioned in the Debenture certificate. The price at which the shares are converted is called as the conversion price.

The date on which the conversion option can be exercised is called as the conversion date or exercise date. The debenture holders may or may not exercise this option.

These convertible securities are usually issued to make the issue attractive and motivate people to subscribe for the securities.

Warrants

A warrant carries the right but not the obligation to its holders to purchase an equity share of a company during a specified time period at a specified price as mentioned in the certificate. He has the right but there is no obligation on part of the warrant holder to exercise the option. The Warrants usually come with an exercise price (Purchase price of the share), Exercise date (date of purchase of the share). Usually warrants are issued to make the issues attractive.

Zero Interest Bond

Usually Bond certificates come with a fixed interest rate and are issued at a Face value with a fixed maturity period. But in some cases, Bond certificates do not carry any interest payment explicitly in the bond certificate. They are called as Zero Interest Bond and are issued at a value much lower than the Face Value. It is supposed to be issued at Discount value, and may be redeemed at par value at the date of Maturity. Till that period no annual interest payments are made. These kinds of bonds are issued by new companies, or company’s having new ventures, when they do not want to commit fixed financial payments in the initial years. Usually these bonds carry longer maturity dates.

Deep discount bond is a zero interest bond which is issued at a price which is much below the par value specified in the bond certificate. It is issued at a deep discount value and redeemed at Par Value at the time of maturity. These bonds carry no interest payments during the tenure period and usually have longer maturity dates. They are also sometimes referred to as Zero coupon bonds. Here coupon rate refers to interest rate, and these bonds don’t make any annual interest payments. Depending on the requirements of the firm, and its interest paying ability these kinds of bonds are issued. In this case, we can see that the Yield to Maturity is higher and therefore, investors prefer to invest in such kind of bond certificates.

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References:

Khan M Y, Jain P K, ‘Financial Management-Text and Problems(3rd edition)’, Tata McGraw Hill Publishing Company Limited.