18 Financing of Enterprise: Role of Agencies for Financial Support
Monica Bansal
1. Learning Outcome:
After completing this module the students will be able to:
- Understand the Stages of Financing an Enterprise
- Understand the Concept of Financing a New Enterprise
- Describe Methods of Estimating Financial Requirements
- Understand the various Sources of Arranging Finance for the Enterprise
- Understanding the Role of Agencies for Financial Support to Enterprises
2. Introduction
The ultimate success of an enterprise depends upon the availability of sufficient finance. In other words, finance is the prerequisite for mobilizing the resources of an enterprise. An enterprise requires finance at every stage of its life cycle. For example, in the inception stage, it needs finance for setting up plant and purchasing fixed assets, such as machines and equipment. However, in the development stage, finance is required for continuous mobilization and up gradation of enterprises to survive and grow in today’s competitive business environment. In addition, the efficient functioning of various departments, such as production, marketing, research and development, of the enterprise depends on smooth flow of finance. For example, the marketing department of an enterprise needs a sufficient amount of funds for promoting and distributing the product. Therefore, an enterprise needs to be prudent while managing finance for a project. The financial needs of an enterprise depend on various factors, such as size and nature of the business.
An enterprise can raise long term finance by issuing equity and preference shares, borrowing capital and using retained earnings. On the other hand, medium term finance can be raised through lease finance, hire purchase and public deposits. Short term finance is raised through trade credit, installment credit, certificates of deposits and bank loans. Apart from this, an enterprise can also raise finance from various financial agencies such as commercial banks and co-operative banks. The Indian government has opened several institutions such as Small Industries Development Organizations (SIDO) and National Small Industries Corporation Ltd (NSIC), to provide financial assistance to small and medium scale entrepreneurs.
Stages of Financing an Enterprise
There are basically two stages of financing an organization:
- Early Stage Financing
- Later Stage Financing
3. Financing a New Enterprise
Every enterprise requires finance for establishing its business and carrying out various related activities. Financing a new enterprise essentially involves two parts, viz, estimating the funds/capital requirement and deciding sources. An enterprise has two types of financial requirements, namely, fixed capital and working capital, which are discussed as follows:
- Working Capital: It is that capital which is invested in current or short-term assets. It covers expenses, such as buying the raw material, payment of wages and salaries, rent, fuel, electricity and water, repairs and maintenance and advertising. The prepaid expenses, cash, inventory and the bills receivable are regarded as current assets. The funds invested in current assets are recovered by realizing cash. Therefore, working capital is also regarded as revolving capital or circulating capital.
- Fixed Capital: The fixed capital helps in purchasing fixed or durable assets, such as land, building, machinery, equipment and furniture. The fixed capital is also known as long term capital. The amount of fixed capital depends mainly upon the nature and size of the business. The manufacturing industries requires huge amount of investment whereas the trading concerns require comparatively lesser investments.
4. Estimating Financial Requirements
An enterprise can raise funds only, if it is clearly determines its financial requirements. Estimating the financial requirements for an enterprise involves determining the total amount of capital required for various needs of the business and deciding the sources and methods to raise it. The financial needs can be fulfilled though the owned capital or the borrowed capital. The financial requirements on the basis of period of use are classified into three types, which are as follows:
- Long-Term Capital: Long term capital is required to finance the fixed capital and permanent part of the working capital. It is raised through various sources, such as by issuing debentures and shares and taking loans and advances from banks and financial institutions. It is the capital which is required for a period of five years or more.
- Medium-Term Capital: This kind of capital is required for performing different activities viz. renovation of buildings, expenditure on advertising and modernization of machinery. This capital can be raised from different sources such as issuing of debentures and shares and reinvestment of accumulated profits. The medium term capital is required for a period of two to five years.
- Short-Term Capital: Short term capital is required to finance the current assets and to meet day-to-day expenses. It can be raised from various sources such as banks, installment credit and trade credit. The short term capital is needed for a period of less than a year.
5. Sources of Arranging Finance for the Enterprise
An enterprise raises funds for different purposes depending on the time period ranging from short to long duration. The total amount of financial needs of an enterprise depends on the nature and size of the business. On the other hand, the aim of raising funds depends on the objectives of the enterprise. An enterprise can opt for various sources of financing, which are mainly three types and are discussed in detail as follows:
5.1 Sources of Long Term Financing
An enterprise needs long term finance for expansion, diversification, technological innovation and research and development projects. It can be raised through different sources depending upon the amount of capital required to complete the project and is explained as follows:
- Equity Financing: Equity financing refers to a method of raising long term funds by selling the common and preferred stock of the enterprise to the investors. The investors get ownership interests in the enterprise in return of amount paid by them for purchasing the common and preferred stock of the enterprise. It can be raised through shares. Shares are easily transferable and involve limited liability of shareholders to the face value of the shares. The shares are basically of two types viz. equity shares and preference shares.
- Debt Financing: Debt financing is a form of financial instrument that provides long term debt to an enterprise. It can be raised through debenture capital, a source to raise debt capital. Debt financing is an agreement between the enterprise and a debenture holder. It clearly indicates that the enterprise would repay the debt at a specified date to debenture holders. If an enterprise raises funds through issuing debentures, it needs to pay a fixed rate of interest at regular intervals. Debenture holders of an enterprise are known as creditors.
- Term Loans: Term loans are the types of long term loans that are raised for the duration of 3 to 10 years from banks and financial institutions. Term loans carries floating rate of interest and have pre-determined maturity period. The main sources of these loans are IDBI, ICICI, Commercial Banks, and IFCI etc. An enterprise uses term loans to purchase fixed assets and fund projects having long gestation period.
5.2 Sources of Medium Term Financing
Medium term financing is required for performing different activities viz. renovation of buildings, expenditure on advertising and modernization of machinery. This capital can be raised from different sources such as issuing of debentures and shares and reinvestment of accumulated profits. The medium term capital is required for a period of two to five years. An enterprise can avail medium term finance through various sources including lease finance and hire purchase, venture capital finance, public deposits and retained earnings. The following figure shows the sources medium term finance:
- Retained Earnings: In retained earnings, the enterprise uses its accumulated profits for future investments, which can be long term and short term in nature. At the end of each financial year, some of the undistributed profits are left with the enterprise. These profits are transferred to reserve funds each year and this funds is known as retained earnings.
- Lease Finance: Lease finance is an agreement between the owner of assets, called the lessor and the user of assets called the lessee. In lease finance, only possession of asset is transferred to a lessee and ownership of the title remains with the lessor. Lessee makes payment to the lessor after a specified period of time to use the asset. This periodical payment is called as lease rent.
- Hire Purchase: In hire purchase, there is an agreement between a hiree who is the owner of the property and a hirer who is the user of the asset. As per this agreement, the hiree transfers his/her asset to the hirer keeping ownership of title with himself/herself and the hirer gets the possession of the asset. In hire purchase, the beneficiary receives the payment from the hirer periodically. The payment made to the hiree is divided into two parts viz. capital repayment and interest.
- Public Deposits: Public deposits are a significant way of raising medium term fund. It can be defined as funds and loans raised from general public, employees and other similar kind of depositors. These are treated as one of the easiest way of raising funds during credit crisis as public is always ready to invest in the profitable projects of different enterprises.
- Venture Capital Financing: It is one of the widely used sources of medium term finance. It is also called risky capital, as it requires to be paid even in case of loss. Venture capital is a form of quasi equity and is generally required by newly established enterprises. The capitalist who invests in venture capital is not similar to bankers and equity shareholders. A venture capitalist acts as a partner, manager and advisor to the enterprise. This type of capital is required at the time of incorporation, expansion and acquisition of a project.
5.3 Sources of Short Term Financing
Short term financing may be defined as the credit or loan facility extended to an enterprise for a period of less than one year. It is a credit arrangement provided to an enterprise to bridge the gap between income and expenditure in a short period of time. It helps the enterprise to manage its current liabilities, such as payment of salaries and wages to labours and procurement of raw materials and inventory. The availability of short term funds ensures the sufficient liquidity in the enterprise. It facilitates the smooth functioning of the enterprise’s day to day activities. The important sources of short term financing are:
- Trade Credit: Trade credit is an arrangement in which the supplier allows the buyer to pay for goods and services at a later date in future. The decision to provide trade credit depends on the mutual understanding of both the buyer and supplier. The supplier takes the decision to extend trade credit after taking into consideration creditworthiness, goodwill and record of previous transactions of the buyer.
- Installment Credit: Installment credit is another source of short term financing, in which the amount that is borrowed is repaid with interest in equal installments. It is also called installment plan or hire-purchase plan. It helps an enterprise in purchasing the new plant and machinery in the absence of funds for a time period.
- Cash Credit: Cash credit is defined as an agreement between the bank and the customers to withdraw cash exceeding their account limit. Cash credit is one of the most important instruments of short term financing. The time limit granted is generally one year which can be further extended by the bank in case of special request by the customer.
- Commercial Papers: It is an instrument used by the enterprise with high credit rating to raise money from the market. It is an unsecured promissory note, which the enterprise offers to the investors either directly or indirectly through the dealer. Commercial papers are generally sold by large enterprises, which have strong goodwill in the market.
- Bank Loan: Bank loan is the amount of money granted by the bank at a specified rate of interest for a fixed period of time. It requires minimum document and legal formalities to pass a loan. Various banks are required to follow certain guidelines to extend bank loans to the customers. For this purpose the bank requires the copy of income proofs and identity of the client and a guarantor to sanction bank loan.
- Certificates of Deposit: This deposit is a type of promissory note which is issued by the bank to the clients for depositing funds in the concerned bank for a fixed time period. The maturity of certificates of deposit is designed in accordance with the necessity of investors. The maturity period of certificates of deposit can range from three months to one year.
- Bills of Exchange: A bill of exchange is a document in which an individual demands the receiver to give payment for services and goods received to a third party at a future date. The individual who writes the bill is known as drawer and t he individual who receives the bill is known as drawee. The individual who pays the bill is known as payee.
- Customer Advances: It may be defined as a part of payment which is given in advance to the enterprise by the customer for the procurement of goods and services in the future. It is also called as Cash Before Delivery (CBD). The enterprise is free to decide whether to refund the money, if the order is cancelled by the customers and it does not require paying interest on customer advances.
- Factoring: Factoring comprises complementary financial services, which is provided to the borrower. The borrower has the freedom to select the set of services provided by the factoring enterprise. Factoring ensures that the services will be given to the clients at a faster pace and with good quality.
- Bank Overdraft: It is a temporary arrangement between the bank that allows the organization to overdraw from its current deposit account with the concerned bank up to a specified limit. This facility is granted against securities, such as promissory notes, goods in stock, or marketable securities. The interest rate which is charged on cash credit and bank overdraft is very high as compared with the rate of interest on bank deposits.
6. Role of Agencies for Financial Support to Enterprises
The financial institutions fund only term loans required for creating fixed assets. The agencies which aid entrepreneurs include State Financial Corporations (SFCs) which are 18 in number in India, Industrial Development Bank of India (IDBI), Small Industries Development Bank of India (SIDBI), Industrial Finance Corporation of India (IFCI) and State Industrial Development Corporations (SIDCs) etc. IDBI, IFCI and SIDBI were only refinancing loan extended to SMEs at the time of their incorporation. IDBI and IFCI were funding large scale industries in addition to underwriting the shares and promoting joint sector ventures. Later their functions have changed and today all of them extend term loan to small scale industries directly and also refinance the loan given by the banks to entrepreneurs. SFCs and SIDCs operate at state level and provide funds for industrial development and are involved in joint sector ventures and underwriting shares. Some of the major agencies which provide financial assistant to entrepreneurs are discussed as follows:
6.1 Small Industries Development Organization (SIDO): For the promotion and development of small scale industries SIDO is the apex authority and the schemes launched by this agency are as follows:
- Credit Linked Capital Subsidy Scheme for Technology Upgradation: It gives capital subsidy at the rate of 15 per cent up to Rs one crore for the technology upgradation for small and medium term organizations in the specified products and sub sectors.
- Integrated Infrastructure Development Scheme: The scheme provides help up to 80 percent or Rs four crore for the state governments, NGOs and industry associations. But initially this assistance was upto 45 percent or Rs two crore, whichever is less for setting up a new industrial undertaking.
- Credit Guarantee Scheme: Under this scheme the loans are given up to a limit of Rs 25 lakhs.
- Small Scale Industries MDA scheme: The scheme provided funds up to 25 per cent of costs for producing publicity material upto Rs two lakh for sector specific subsidies and 90 percent for to and fro air fare to the small entrepreneurs for attending in fairs and exhibitions abroad.
- ISO 9000/ISO 14001 Certification Reimbursement Scheme: This facility is given for obtaining ISO 9000 to the limit of 75 percent or Rs 75000, whichever is less.
- Micro Finance Programme: This facility is given for graduate the entrepreneurs from consumption and production credit to start a small new venture.
- Help to Entrepreneurship Development Institutes: For developing the training infrastructure 50 per cent or Rs one crore, whichever is lower is given to the state governments.
6.2 National Small Industries Corporation Limited (NSIC): This is a creative agency and an initiative of the central government of India. It is a government organization which provides credit support, technology support, marketing support and other support services for the growth and development of entrepreneurs and their organizations and these are:
- Credit Support Schemes: The credit requirements of small scale industries are facilitated by NSIC such as:
Financing for Procurement of Raw Material: The agency takes care of all the procedures, documents and issue of letter of credit and other bank related documents in case of imports required for the purchase for raw materials. Heavy discounts are given to SSIs for bulk purchases.
Financing through Syndication with Banks: With the help of strategic alliances between the commercial banks and the small enterprises facility of funds are provided.
Equipment Financing: By availing the facility of installment purchase, hire purchase and term loan the finance is given to SSIs for purchasing equipments.
Financing for Marketing Activities: Various .marketing facilities such as internal marketing, rural marketing, exports and bill discounting facilities are given.
- Technology Support Scheme: The services provided under this scheme are the recommendations on application of new techniques, material testing facilities in the special laboratories, environment and energy services at selected centres, practical as well as theoretical training for the upgradation of skill.
- Marketing Support Scheme: NSIC promote small industries products and has introduced a number of schemes to support small enterprises in their marketing activities and enhance its market share.
- Performance and Credit Rating Schemes for Small Industries: The credit rating agencies enable the small enterprises to conduct the SWOT analysis of their current activities and take prompt action.
All the financial institutions are government owned and controlled and hence promote industrialization in the country by implementing the schemes of the government and provide refinance on the advances given to the entrepreneurs.
6.3 Banks
The Indian banking sector under the aegis of Reserve Bank of India (RBI) may be classified under three heads namely Commercial Banks, Regional Rural Banks (RRBs) and Co-operative Banks. In the commercial banks group, there are public sector banks and private sector banks. Under public sector banks there are State Bank Group and Nationalized Banks. In State Bank group we have State Bank of India and its subsidiaries. Except private sector bank all the banks are backed by the government and follow the government directions issued through RBI. As regards cooperative banks which are mainly in to financing agriculture sector do get their refinance from NABARD on the advance that they extend to non-farm sector activites i.e. industrial activity.
Schemes for Providing Assistance to Entrepreneurs by these banks
- Working capital finance, extended to all segments of industries and service sector.
- Deferred payment guarantees to support purchase of capital equipment.
- Corporate term loan to support capital expenditure for setting up new ventures as also for expansion, renovation, technology Upgradation and venture capital etc.
- Loans for small business borrowers, export and import finance and advance against shares.
- Some private sector banks also extend loans to SMEs. But their main purpose is to maximize their wealth.
- Summary
Finance is the prerequisite for mobilizing the resources of an enterprise. An enterprise requires finance at every stage of its life cycle. For example, in the inception stage, it needs finance for setting up plant and purchasing fixed assets, such as machines and equipment. However, in the development stage, finance is required for continuous mobilization and up gradation of enterprises to survive and grow in today’s competitive business environment. In addition, the efficient functioning of various departments, such as production, marketing, research and development, of the enterprise depends on smooth flow of finance. In this module various sources of finance has been discussed in detail. The main emphasis in this module is on discussing the role of agencies for providing financial support to the entrepreneurs.