SOURCES OF BUSINESS FINANCE XII COMMERCE SP NEW

SYLLABUS

2.1 Introduction
2.2 Nature and significance of finance
2.3 Financial requirements and Sources
2.4 Methods of raising finance
(A) Equity and Preference shares
(B) Retained profits
(C) Debentures and Bonds
(D) Public deposits
(E) Loan from financial institutions
(F) Loan from commercial banks
(G) Trade credit
(H) Discounting of bills of exchange
(I) Global Depository Receipt and American Depository Receipt

2.1 INTRODUCTION
A business transaction involves buying and selling. Buying means payment of
money and selling means receipt of money. The transaction may involve immediate
payment or it may be
.
on credit terms. Thus finance plays very important role in every
business transaction. Finance is the life blood of business economy. It provides basis for
every business activity.

Unit objective :
After studying this chapter you should able to know various sources of finance
and their significance in the business i.e. shares, debentures, bonds, retained profits,
public deposits, loans, trade credits, discounting bills of exchange, GDR and ADR.

2.2 NATURE AND SIGNIFICANCE OF FINANCE
In Sanskrit saying 'Artha Sachivah' (DeLe&: meefeJe:) which means "Finance
is the supreme controlling factor" which brings the significance of 'finance'.
Finance is what finance does. It is a study of money. An understanding of 'What
money is ?' and 'What money does?' is the base of financial knowledge.

1. Finance may be defined as the provision of money at the time it, is wanted. It is
necessary through out the activities of promotion, orgnisation and regular operations of
business. It must take care of all financial needs of business.

2. Finance holds the key to all business activities. A business activity cannot be pursued
without financial support. Finance contributes to different business functions such as
purchasing, production, marketing and so on. It administers every business activity.
Thus finance is the central theme of any business proposition.
3. Finance enables the business to pay its obligations promptly and without any difficulty.
Finance is accepted as weapon to pay its bills promptly.

4. Finance is concerned not only with measuring profitability but setting minimum
standards for profitability. It is also concerned with measuring cost of capital for any
given industry.

5. Finance is required to generate finance. Its generation depends upon a co-ordination of
different business functions. The financial proposition would be successful, if it is used
effectively in different business activities. Thus finance is said to be 'circulatory system'
of economic body. It makes possible co-operation between many units of business
activity.

Thus, finance is a 'specialized operation'. It is an inseparable, part of business
administration. Finance has been described in several ways. It is related to money and
money, management. It is also related to the inflow and outflow of funds. In fact it is a
sinew i.e. strength of business activity. Finance is aptly described as key determinant of
success of business.

Inconclusion it may be stated that all activities or functions of a business are
ultimately related to finance.

2.3 FINANCIAL REQUIREMENTS AND SOURCES
Fund raising is not merely a question of how much money is to be raised, but in
what form should the finance be raised is an important matter of policy.

A businesses organization requires finance
(a) For various purposes,
(b) At different stages and
(c) For different period.

Even the size and nature of its business, determines the actual requirement of
funds. Business organization collects huge funds
.
through different sources.

The various sources of finance available to business may be classified as
(A) External Sources.
(B) Internal Sources.

(A) External Sources : External sources are outside of the firm. They are used
extensively for collecting initial capital. The important external sources are -

1) Issue of shares
2) Issue of debentures
3) Public deposits
4) Loan from institutions
5) Bank Credit

(B) Internal Sources : Internal sources are available within the firm. They develop after
few years of profitable working of the firm. The important internal source of finance is
'retained profit'. It is also called as 'ploughing back of profit'. Here the undistributed
profit of the firm is reinvested in the business.

The external source and internal source, may be further classified as
(a) Long term source
(b) Short term source
(a) Long term source : A business firm requires long term finance for meeting fixed
capital needs. These funds are required generally for long duration. The main sources
of long term finance may lie divided into

(1) Owned Capital
(2) Debt Capital

(b) Short term source : The short term funds are required for meeting working capital
requirement. These funds are required for a short period. The short term funds can be
arranged from taking short term loans, accepting deposits, etc.

The various sources of finance available to business, may be explained with following
chart.

Sources of finance

2.4 METHODS OF RAISING FINANCE

A) Shares
The term 'share' is defined by section 2(46) of the Companies Act -1956 as -
"share means a share in the share capital of a company and includes the stock where a
distinction between stock and shares is expressed or implied".

Share is a unit by which the share capital is divided. Share is a small unit of the
capital of a company. The total capital of company is divided into small parts and each
such part is called 'share'. The capital of company is divided into large number of
shares. It facilitates the public to subscribe the capital in smaller amount. Thus a share
is indivisible unit of share capital.

A person can purchase any number of shares as he wishes. A person who
purchases shares of a company is known as a shareholder of that company.

Features of Shares

1. A share is the smallest unit of share capital.

2. It shows the ownership of a shareholder.

3. Each share has distinct number, which is noted in the share certificate.

4. Share is a movable property of a member.

5. A share
-
is not any visible thing. It is shown by share certificate or in the form the
'demat' share.

6. Each share has value expressed in terms of money. There may be

a) Face value : This value is written on the share certificate and mentioned in the
Memorandum of Association.

b) Issue value : It is the price at which company sells its shares. For example, issue at
par or at premium or at discount.

c) Market value : This value of share is determined by demand and supply forces in the
share market.

7. A Shareholder is entitled to get a share in the net profit of the company. It is called
'dividend'.

8. A company can issue two types of shares -
a) Equity shares b) Preference shares

Kinds of shares
There may be different types of shares depending upon right to control, income,
and risk. The following chart gives the snapshot view of different kinds of shares.


SHARE

Equity Shares Preference shares
(i) Equity shares with i) Cumulative preference shares
normal voting eight ii) Non Cumulative preference
(ii) Equity shares with shares
differential voting right iii) Participating preference shares
iv) Non Participating preference
shares
v) Convertible preference share
vi) Non Convertible preference share
vii) Redeemable preference shares
viii) Non Redeemable preference
shares

1. Equity Shares
Equity shares are also known as 'ordinary shares' For legal reason, a company
can not exist without equity shares.

Companies Act 1956 defines equity shares as "those shares which are not
preference shares'".

The above definition reveals the two important features of equity shares

1. The equity shares do not enjoy preference in getting dividend.

2. The equity shares do not have priority for payment of capital at the time of winding up
of the company.

Thus, equity shareholders do not enjoy any special privilege in respect of
payment of dividend and repayment of capital at the time of winding up of the
company.

Equity shares are fundamental and basic source of financing activities of
business. Equity shareholders own the company and bear ultimate risk associated with
the ownership. They bear maximum risk of business. After paying claims of all other
investors the remaining funds belong to equity shareholders. Thus equity shareholders
are 'residual claimants' against the assets and income.

Equity shares do not carry any, fixed commitment charge. They are paid
dividend at the rate recommended by Board of Directors. If there is no profit, no
dividend will be payable. Similarly if there is less profit lesser dividend will be paid. It is
exactly because of this position, equity capital is known as `Risk capital'. The owners of
equity shares are real risk bearers.

However, equity shareholders participate in the management of the company.
They are invited to general meeting and are given normal voting rights. They elect their
representatives for the management of the company. Equity shareholders are real
owners of the company.

Features of equity shares

1. Permanent capital : Equity, shares are irredeemable shares. The amount received
from equity shares is not refundable by the company during the life time. Equity shares
become redeemable, only in the event of winding up of the company. Equity
shareholders provide long term and permanent capital to the company.

2. Fluctuating dividend : Equity shares do not have a fixed rate of dividend. The rate of
dividend depends upon amount of profit earned by company. If company earns more
profit, dividend is paid at higher rate. On the other hand if there is insufficient profit,
Board of Directors may postpone the payment of dividend. The shareholders can not
compel them to declare and pay the dividend. The income of equity shares is irregular
and uncertain. They get dividend which is always fluctuating.

3. No preferential right : Equity shareholders do not enjoy preferential right in respect
of payment of dividend It means equity shareholders are paid dividend only after
dividend on preference shares has been paid.

At the time of winding up of the company also the equity shareholders are paid in the
last. They are the last claimants. If no surplus amount is available after paying debts
and preference shares, equity shareholders will not get anything. Thus, equity
shareholders stand second in case of getting dividend on their shares as well as getting
back their capital at the time of liquidation of company.

4. Rights : Equity shareholders enjoy certain rights. These include

a) Right to share in profit, when distributed as dividend, is the most important right of
equity shareholder. If company is successful and makes handsome profit, they have
advantage of large dividend.
b) Right to vote is the basic right of equity shareholders by Which they elect directors,
amend Memorandum, Articles etc.

c) Right to inspect books of account of their company of which they are owners.

d) Right to transfer shares is one of the most important right of shareholder.

5. Control : The control of company is vested in equity shareholders. They are often
described as real masters of the company. It is because they enjoy exclusive voting
right. The voting rights of equity shareholder are protected as far as possible. Equity
shareholders may exercise their voting rights by proxies, without attending meeting in
person. The Act provides the right to cast vote in proportion to number of
shareholdings.

Equity shareholders participate in the management of the company. They elect their
representatives called Directors on the Board for the management of company.

6. Risk : Equity shareholders. bear maximum risk in the company. They are described as
'shock absorbers' when company has financial crisis. If the income of company falls, the
rate of dividend also comes down. Due to this, market value of equity shares goes
down resulting into capital loss. Thus, equity shareholders are main risk takers.

7. Residual claimants : Equity shareholders are owners and they are residual claimants
to all earning after expenses, taxes, etc. have been paid.

Although equity shareholders are last claimants they have advantage of receiving entire
earnings that is left over.

8. Face value : The face value of equity shares is low, in comparison to preference
shares. It is generally Rs 10/- per share or even Rs 1/- per share.

9. Market Value : There is more fluctuation in the market value of equity shares in
comparison to other securities. Therefore, equity shares are more appealing to the
speculators.

10. Bonus and Right Issue : Bonus shares are issued as gift to equity shareholders. They
are issued 'free of cost' to them. These shares are issued out of accumulated profits.
These shares are issued to existing equity shareholders in certain ratio or proportion of
their existing shareholdings.

Equity shares get the benefit of rights issue. When a company raises further capital by
issue of shares, the existing shareholders are given priority to get newly offered shares.
This is called right issue. Thus equity shareholders get the advantage of bonus and
right issue.

11. No charge on assets : The equity shares do not create any charge on assets of the
company.

"It is often said that equity shareholders do not enjoy any special privilege, though
they have special rights". How would you comment on this contradiction?

Types of equity shares
As per Section 86 of Indian Companies Act 1956, as amended by the Companies
(Amendment) Act 2000, the equity share capital can be of two types

(i) with normal voting right
(ii) with differential voting right

(i) Equity shares with normal voting right: Voting right of such equity holders shall be in
proportion to his share of paid up equity capital.

(ii) Equity shares with differential voting right: Voting right of such equity holders shall be
as to dividend, voting or otherwise in accordance with Companies Rule 2001.

Due to the provision for issuing such shares, company can issue shares with
limited voting rights or no voting rights. They may be entitled to extra rate of dividend
if any.

2. Preference shares
As the name indicates, these shares have certain privileges and preferential
rights distinct from those attaching to equity shares.

The shares which carry following preferential rights are termed as preference
shares.

(a) A preferential right as to the payment of dividend during the life time of the company.

(b) A preferential right as to the return of capital in the event of winding up of the
company.

Holder of these shares have a prior right to receive the fixed rate of dividend
before any dividend is paid to equity shares. The rate of dividend is prescribed in the
issue.

Normally preference shares carry no voting power. They have voting right only
on those matters which affect their interest such as selling of undertaking or changing
rights of preference holder, etc.

The preference shareholders are co-owners of the company but not controllers.
These shares are purchased by cautious investors who crave for safety of principal and
are satisfied with low but definite and regular income. Preference shares occupy on 'in
between' position in the capital structure.

Features of preference shares
1. Preferential dividend : The dividend is payable to preference shareholders before
anything else is paid to equity shares. The company must assure their preferential right
as to payment of dividend during the life of the company.

2. Prior repayment of capital : Preference shareholders have a preference over equity
shareholders in respect of return of capital when the company is liquidated. It saves
preference shareholder from capital losses.

3. Fixed return : These shares carry dividend at a fixed rate. The rate of dividend is
predetermined. It may be in the form of fixed sum or may be calculated at a fixed rate.

One point must be made clear. The preference shareholders are entitled to dividend
which can be paid only out of profit. Although the rate of dividend is fixed, the
directors; in financial prudence, decide that no dividend be paid as there are no profits,
the preference shareholders have no claims for dividend.

4. Nature of capital : Preference shares do not provide permanent share capital. They
are redeemed after certain period of time. As per Companies (Amendment) Act 1988, a
company can not issue irredeemable preference shares.

5. Market value : The market value of preference share does not change as-the rate of
dividend payable to them is fixed. The capital appreciation is considered to be low as
compared with equity shares.

6. Voting right : The preference shares do not have normal voting rights. They have
voting rights in respect of those matters which affect their interests. The preference
shares do not enjoy right of control on the affairs of the company.
7. Risk : The investors who are cautious, generally purchase preference shares. Safety of
capital and fixed return on investment are advantages attached to preference shares.
They attract moderate type of investors. These shares are boon for shareholders during
depression period when interest rate is continuously falling.

8. Face Value : Face value of preference shares is relatively higher than that of equity
shares. They are normally issued at a face value of Rs. 100/-

9. Right or Bonus issue : Preferential shareholders are not entitled for right or bonus
shares.
"Preference shareholders are the owners but not controllers."
Do you agree with this statement? Discuss.

Kind of preference shares

Preference shares

1. Cumulative preference shares :
Cumulative preference shares are those shares on which dividend goes on accumulating
until it is fully paid. This means, if the dividend is not paid in one or more years due to
inadequate profit, then such unpaid dividend gets accumulated. The accumulated
dividend is paid when company performs well. The arrears of dividend. are paid before
making payment to equity shareholders. The preference shares are always cumulative
unless otherwise stated in the Articles of Association. It means that if dividend is not
paid in any year or falls short of prescribed rate, the unpaid amount is carried forward
to next year and so on; until all arrears have been paid.

2. Non-cumulative preference shares - Dividend on these shares does not
accumulate. This means, the dividend on shares can be paid only out of profits of that
year. The right to claim dividend will lapse, if company does not make profit in that
particular year. If dividend is not paid in any year, it is lost.

3. Participating preference shares : The holders of these shares are entitled to
participate in surplus profit besides preferential dividend. The surplus profit which
remains after the dividend has been paid to equity shareholders up to certain limit, is
distributed to preference shareholders.

4. Non-participating preference shares : The preference shares are deemed to be
non-participating, if there is no clear provision in Articles of Association. These
shareholders are entitled only to fixed rate of dividend prescribed in the issue.
5. Convertible preference shares : These shareholders have a right to convert their
preference shares into equity shares. The conversion takes place within a certain fixed
period.

6. Non-convertible preference shares : These shares can not be converted into equity
shares.

7. Redeemable preference shares : Shares which can be redeemed after a certain
fixed period are called redeemable preference shares. A company limited by shares, if
authorized by Articles of Association, issues redeemable preference shares. Such shares
must be fully paid. These shares are redeemed out of divisible profit only or out of fresh
issue of shares made for this purpose.

8. Irredeemable preference shares : Shares which are not redeemable i.e. payable
only on the winding up of the company are called irredeemable preference shares. As
per Companies Act (Amendment made in 1988) the company can not issue
irredeemable preference shares.

Distinction between
Sr.
No.
Points Equity Shares Preference shares
1. Meaning Equity shares have no priority
right while receiving dividend
and repayment of capital at
the time of winding up of
company.
Preference shares carry
preferential right in respect of
dividend payment and
repayment of capital in
winding up of company.
2. Rate of
dividend
Equity share holders are given
dividend at fluctuating rate
depending upon the profits of
the company.
Preference share holders get
divided at fixed rate.
3. Vote right Equity shareholders enjoy
normal voting right. They
participate in the management
of their company.
Preference shareholders do
not enjoy normal voting right.
They can vote only on matters
affecting their interest.
4. Nature of
capital
Equity share capital is
permanent capital. It is known
as 'Risk capital'
Preference share capital is
'safe capital with stable return
5. Nature of
Investor
The investor who are ready to
take risk invest in equity
shares.
The investors who are
cautious about safety of their
investment, invest in
preference shars.
6. Face value The face value of equity
shares is generally Rs. 1/- or
Rs. 10/- It is relatively low.
The face value of preference
shares is relatively higher i.e.
Rs. 100/- and so on.
7. Types Equity shares are classified
into
a) equity voting with normal
voting right
b) equity shares with different
voting right
Preference shares are
classified as
a) Cumulative preference
shares
b) Non-cumulative preference
shares
c) Convertible preference
shares.
d) Non-convertible preference
shares
e) Redeemable preference
shares
f) Irredeemable preference
shares
g) Participating preference
shares
h) Non-participating
preference shares
8. Right and
bonus issue
Equity shareholder is entitled
to get right and bonus shares.
Preference shareholders are
not eligible for right and
bonus shares.
9. Capital
appreciation
Market value of equity shares
increases with the prosperity
of company. It leads to
increase in the value of
shares.
Market value of preference
shares does not fluctuate. So
there is no possibility of
capital appreciation.
10. Risk Equity shares are subject to
higher risk. That is because of
fluctuating rate of dividend
and no guarantee of refund of
capital and repayment of
capital
Preference shares are subject
to less risk. It is because of fix
rate of dividend and
preferential right as regards
dividend and repayment of
capital.

(B) Retained profits
Business organizations are subject to variation in earnings. It would be a wise
decision on the. part of management, to keep aside a part of earning during a period of
high profit. It helps a company to overcome the downswing in the business cycle.

Retained profits are earnings of the company which are retained in the business.
It is a sum total of those profits, accumulated over years and reinvested in the business
rather than distributed as dividend.

"The process of accumulating corporate profits and their utilization in business is
called retained earning".

In simple words, a part of net profit which is not distributed to shareholders as
dividend, is retained by company in the form of 'reserve fund'. These reserves are
`retained profits' of the company. The policy of using such retained profit in the
business is known as `self financing' or 'ploughing back of profit'. The management can
convert this retained profit into permanent capital which is known as 'capitalisation of
profit' by issuing bonus shares.

Retained profits is an important source of internal financing. It is a simple arid
the cheapest method of raising finance. It is used by established companies.

Determinants of retained profits

1. Total earning of company : If there is ample profit, company can save and retain
some part of profit. 'Larger the earnings, larger the savings', is the principle put forth by
economist J.M. Keynes. It is also a subject of attitude of top management to determine
the part of retained earings.

2. Taxation policy : The taxation policy of government is also an important determinant
of corporate savings. If the taxes are levied at high rates, company can not save much
of the profit to be retained by it.

3. Dividend policy : It is policy of Board of Directors in regards to distribution of profit. A
conservative dividend policy is needed for having good accumulation of profit. This
policy affects shareholders as they get dividend at low rate.

4. Government control : A government is regulatory body of economic system of the
country. Its policies, rules and regulations compel companies to work in that direction.
A company has to formulate its dividend policy in accordance with the rules and
regulations framed by government.

'Retained profit in an enterprise is mixed blessing'. Discuss the points.

(C) 1. Debentures

Debentures have occupied a
.
significant position in the financial structure of the
companies. It is one of the main sources of raising debt capital to meet long term
financial needs.

Debentures represent borrowed capital. The debenture holders are creditors of
the company. The debenture holder gets a fixed rate of interest as return on his
investment. Board of Directors has the power to issue debentures.

The term 'debenture' has come from Latin word 'debare', which means to 'owe'.
Palmer defines a debenture as -

"an instrument under seal evidencing debt, the essence of it being admission of
indebtedness"

Tophan defines

"a debenture is a document given by a company as evidence of debt to the
holder, usually arising out of loan and most commonly secured by charge."

The above definitions bring out the clear meaning of debenture. Firstly it is an
instrument issued in the form of 'debenture certificate' under the common seal of the
company. Being an instrument it is transferable. It is an evidence of indebtedness. Thus
debenture holder is creditor of the company. Being a loan it is secured by charge on
asset. It is refundable.

The term debenture has not been defined clearly under Companies Act 1956.

Sec 2 (12) of companies Act 1956 only states that, "the word debenture includes
debenture stock, bonds and any other security of the company whether constituting a
charge on asset of the company or not."

Under the existing definition debenture means a document which either creates
or acknowledges debt. Ordinarily debenture constitutes a charge on company, on some
part of its property, but there may be a debenture without such charge.

Here a point to be noted that as per Companies (Amendment) Act 2000,
company can not issue unsecured debentures.

Characteristics of Debentures a snap shot view

Promise Face value
Time of payment Interest
Assurance of repayment Parties to debenture
Rights of debenture holders Terms of issue
Security Listing

Characteristics of Debentures

1. Promise : Debenture is a written promise by company that it owes specified sum. of
money to holder of the debenture.
2. Face value : The face value of debenture normally carries high denomination. It is Rs.
100/- or multiples of Rs. 100.

3. Time of payment : Debentures are issued with due date stated in the 'Debenture
Certificate'. A debenture provides for the repayment of principal amount on maturity
date.

4. Interest : A fixed rate of interest is agreed upon and is paid periodically in case of
debentures. The rate of interest that company offers depends upon the market
conditions and nature of the business.

5. Assurance of repayment : Debentures constitute a long term debt. They carry an
assurance of repayment on due date.

6. Parties to debentures : There are certain parties to debentures such as

a) Company : This is the entity which borrows money.

b) Trustee : This is a party through whom the company deals with debenture holders. The company
makes an agreement with trustees and debenture holders. It is known as `Trust Deed'.
It contains the obligations of company, rights of debenture holders, etc.

c) Debenture holders : These are the parties who provide loan and receive `debenture certificate' as evidence
of participation.

7. Rights of Debenture holder : Debenture holders have no right to vote at general
meeting of the company.

8. Terms of issue of debentures :
a) Debentures can be issued at par, at premium and even at discount.
b) According to Companies Act, company can not issue debentures carrying voting rights.
c) According to Companies Act, Sec 292 (1) the Board of Directors has the power to issue
debentures.

9. Security : Debentures can be secured with some property of the company.

10. Listing : Debentures must be listed with at least one recognized' stock exchange.

Types of Debentures

Debentures


The debentures can be of different kinds according to their terms of issue,
conversion, provision of security, repayment etc. Let us discuss them in detail.

1. Secured debentures : The debentures can be secured. The property of company may
be charged as security for loan. The security may be for some particular asset (fixed
charge) or it may be the asset in general (floating charge). The debentures are secured
through `Trust Deed'

2. Unsecured debentures : These are the debentures that have no security. The issue
of unsecured debenture is now prohibited by Companies (Amendment) Act, 2000.

3. Registered debentures : Registered debentures are those on which the name of
holders are recorded. A company maintains a register of debenture holders in which the
names, addresses and particulars of holdings of debenture holders are entered. The
transfer of debentures in this case requires the execution of regular transfer deed.

4. Bearer debenture : Name of holders are not recorded on the bearer debentures.
Their names do not appear on the register of debenture holders. Such debentures are
transferable by mere delivery. Payment of interest is made by means of coupons
attached to debenture certificate.

5. Redeemable debentures : Debentures are mostly redeemable i.e. payable at the end
of some fixed period, as mentioned on the debenture certificate. Repayment can be
made at fixed date at the end of specific period or by instalments during the life time of
the company. The provision of repayment is normally made in a trust deed.

6. Irredeemable debentures : These kind of debentures are not repayable during life
time of the, company. They are repayable only after the liquidation of the company or
when there is breach of any condition or when some contingency arises.

7. Convertible debentures : Convertible debentures give the right to the holder to
convert them into equity shares after a specific period. Such right is mentioned in the
debenture certificate. The issue of convertible debenture must be approved by special"
resolution in general meeting before they are issued to public. These debentures are
advantageous for holder. Because of this conversion right, convertible debenture holder
is entitled to equity shares at a rate lower than market value and even he participates
in the profit of the company.

8. Non-convertible debentures : Non convertible debentures are not convertible into
equity shares on maturity. These debentures are normally redeemed on maturity date.
These debentures suffer from the disadvantage that there is no appreciation in value.

Why have debentures not made much progress in Indian capital market?
Discuss with your teacher.

Distinction between

Sr.
No.
Points Shares Debenture
1. Meaning It is a smallest unit in the total
share capital of the company.
Debenture is an instrument
under seal evidencing debt.
2. Nature It is a permanent capital. It is
not repaid during the life time
of the company.
It is temporary capital.
Generally it is repaid after a
specific period.
3. Status Share capital is ownership
capital. A shareholder is the
owner of the company.
Debenture capital is borrowed
/ loan capital. A debenture
holder is creditor of the
company
4. Voting right Shareholder being owner
enjoys voting rights.
Shareholders participate in the
management of the company.
Debenture holder being
company's creditor does not
have any voting right. He can
not participate in the
management of company.
5. Return on
investment
Shareholders are paid divided
Equity shareholders receive
Debenture holders are paid
interest at fixed rate. Interest
dividend at fluctuating rate
where as preference
shareholders receive divided
at fixed rate.
is paid even when company
has no profit.
6. Security Share capital is unsecured
capital. No security is offered
to the shareholder.
Debenture capital being loan
capital is secured by creating
a charge on its property.
7. Time of issue Shares are issued in the initial
stage of the company
Debentures can be issued at
the later stage, when the
company has securities to
offer.
8. Types Shares are classified into two:
a) Equity shares
b) Preference shares
Debentures can be issued at
the later stage, when the
company has securities to
offer.
9. Position on
liquidation
On liquidation of a company
shareholders rank last in the
list of claimants.
Debenture holders being
creditors rank prior to
shareholders for repayment
on liquidation of company.
10. Suitability Shares are suitable for long
terms finance.
Debentures are suitable for
medium term finace.

(C) 2. Bonds
Bond is a debt security. The company borrows money and issues bonds as
evidence of

debt. Bond holder is creditor of the company. The amount of interest is paid
ort bond. It is a fixed charge and must be paid even profit is not available. All bonds
have maturity date and is paid off in cash at certain date in future. Since they axe
creditors and non-owners, they are not entitled to participate in general meeting.

According to Webster Dictionary, 'a bond is an interest bearing certificate issued
by a government or business lira, promising to pay the holder a specific sum at a
specified date.

Thus a bond is a formal contract to repay borrowed money with interest. Interest
is payable at fixed interval or on maturity of bond. Bond is a loan. The holder of bond is
lender of the institution. He gas fixed rate of interest.

Features of Bonds

1. Nature of finance : It is a debt or loan finance. It provides long term finance. The
bondscan. be issued for longer period i.e. 5 years, 10 years and so
.
on.

2. Status of Investor : The bondholders are creditors. Bond is a kind of security for a
loan/debt taken. Bondholder has no right to vote and to participate in the management.

3. Return on bonds : The bondholders get a fixed rate of interest. It is payable on the
maturity or at regular interval. Interest payable to bondholder is a fixed charge.

4. Repayment : A bond is a formal contract to repay borrowed money. Bonds have
specific maturity date at which time the repayment of principal is due.

Types of Bonds

Bonds continue to be the most important corporate securities. They are of such a
large variety that it is very difficult to arrive at a single classification. There are
variations in terms and conditions, purpose of issue, methods of paying interest
and
,
principal, features etc. There is a lot of overlapping in classification of bonds.
Therefore, we shall classify the few of them in simple manner.
Bonds

Based on coupon Based on option Based on Redemption
1. Fixed rate bonds 1. Bond with 1. Single Redemption
2. Floating rate bonds call option 2. Amortising Bonds
3. Zero coupon bonds 2. Bonds with
4. Deep discount bonds put option
5. Inflation - indexed bonds.

(a) Based on coupon / interest

1. Fixed rate bonds : Fixed rate bonds have the coupon that remains constant
throughout the life of the bond.

2. Floating rate bonds : These bonds have variable rate of interest. Interest rates are
recalculated periodically.

3. Zero coupon bonds : No coupons are paid to zero coupon bonds. The bond is issued
at discount. On the maturity these bonds are redeemed at par. The difference between
acquisition cost of bond and face value of bond is profit to investor.

4. Deep Discount bonds : These bonds are similar to zero interest bonds but have huge
discount and long period of maturity i.e. 25 years and more. These bonds are not
entitled to any interest. The difference between cost and maturity value is profit for the
investor.

5. Inflation - indexed bonds : The principal amount of bond and the interest payments
are indexed in inflation. The principal amount grows and payment of interest increases
with the inflation.

(b) Based on option
1. Bond with call option (Callable bonds) : This feature gives right to issuer, the right
to redeem his issue of bonds before maturity of bonds at the predetermined price and
date.

2. Bond with put option (Puttable Bond) : This feature gives bondholder the right to
sell their bonds back to issuer at the pre-determined price and date.

(c) Based on redemption

1. Bonds with single redemption : In this case, principal amount of bond is paid at the
time of maturity only.

2. Amortising Bonds : In this case, payment is

made by borrower on maturity, includes
both interest and principal.

Collect information about various latest bond issued by government and financial
institutions. Note down the features of bonds.

(D) Public Deposits

Public deposit is an important source of financing short term requirement of
company. Companies generally receive public deposits for the period ranging from 6
months to 36 months.

Under this method, general public is invited to deposit their savings with the
company for varied period. Interest is paid by companies on such deposits. The rates of
interest are higher than those allowed by commercial banks. The company issues
'Deposit Receipt' to the depositor. The term of deposit is mentioned in the 'Deposit
Receipt'. Deposit Receipt is an acknowledgement of debt by the company. Deposits are
unsecured loans offered to company. It is considered as risky investment but investors
can earn high return on public deposits.

Companies Act 1956, Section 58-A, provides the power to the central
government to make rules and regulations for controlling public deposits. Government
of India has made Companies (Acceptance of Deposits) Rule 1975. These rules are as
under

1. Ceiling on deposits :

a) Company can accept public deposits up to the 25% of total paid up capital and free
reserves.
b) Company can accept public deposits from existing shareholders and debenture holders
up to 10% of total paid up capital and free reserves.

2. Maturity of Deposits : Company has to accept, deposits from public minimum for 6
months and maximum for 36 months.

3. Interest on deposits : Company can fix rate of interest on deposit money according
to the regulations of Reserve Bank of India.

4. Register of Deposit : Company should record name, address, deposit money, date,
maturity date, rate of interest in `Register of Deposits'.

5. Status of Deposit holder : Deposit holders are creditors of the company.

(E) Loan from financial institutions

First Industrial Policy was declared in 1948 for rapid industrial development in
the country. The Government of India established special financial institutions for
providing industrial finance. There are 12 financial institutions .at
.
national level and 46
at, state level. These institutions provide medium and long term finance. The assistance
of these institutions has become important for new companies as well as going
concerns.

The following chart will give brief idea about the network of All India Financial
Institutions. They are classified into four categories as follows

Finance Institutions

Development Financial Investment State level
Banks Institutions Institutions Institutions
1. IDBI 1. RCTC 1. LIC 1. SFC
2. IFCI 2. TDICI 2. UTI 2. SIDC
3. ICICI 3. TFCI 3. GIC 4. SIDBI
5. IRBI

I. Development Banks
1. Industrial Development Bank of India (IDBI)
2. Industrial Finance Corporation of India Ltd. (IFCI)
3. Industrial Credit and Investment Corporation of India Ltd. (ICICI)
4. Small Industries Development Bank of India (SIDBI)
5. Industrial Reconstruction Bank of India (IRBI)

II. Financial Institutions
1. Risk capital and Technology Finance, Corporation Ltd. (RCTC)
2. Technology Development and Information Company of India Ltd (TDICI)
3. Tourism Finance Corporation of India Ltd. (TFCI)
III Investment Institutions
1. Life Insurance Corporation of India (LIC)
2. Unit Trust of India (UIT)
3. General Insurance Corporation of India (GIC)

IV State level institutions
1. State Financial corporations (SFC)
2. State Industrial Development Corporation (SIDC)

Above mentioned institutions provide assistance in the following forms :-
1. To subscribe to shares / debentures
2. To underwrite the issue of securities
3. To lend money
4. To guarantee term loans raised by company

Importance and need of institutional financing

1. To develop sound capital market : Financial institutions help in developing a sound
financial capital market. They help in promotion and financing of business enterprises
either by underwriting issues or by subscribing shares.

2. To mobilize financial resources : Most of the economically backward countries fail
to mobilize financial resources for development of industry. Capital is reluctantly
provided to new ventures. Financial corporations have become significant for economic
betterment of such countries. They held initial investigation and bear pioneering risk.

3. Capital formation : Under developed countries suffer from shortage of finance due to
low rate of capital formation. The gap between saving and investment is filled by such
finance corporations. They have taken the position of investors.

4. Planned economy : A special finance corporation plays an important role in planned
economic development of country. The projects of national importance are taken up by
these corporations so that scarce finance resources can be utilized at the optimum
level. Certain basic industries can be developed by government through these special
bodies.

5. Financing small business : Special corporations have been established for financing
the small scale industries. The problems related to small business are of special
character. They can be tackled by financial institutions created specially for this
purpose.

6. Foreign exchange need : The shortage of foreign exchange is also one of the factors
for development of these institutions. These institutions provide long term loans in
foreign currencies also. Even first rate companies seek the assistance of these
institutions.

7. Government taxation policy : The interest payable on borrowed fund is a deductible
charge from profit and loss account, resulting in 'Tax-shield'. Therefore, business units
are more dependent on debt capital. These finance institutions are the best source of
debt.

8. Rate of Interest : These corporations charge uniform rate of interest, irrespective of
amount of loan, in relation to total cost. This has also led to borrow heavily from these
institutions.

(F) Loans from commercial banks

Commercial banks play an important role in providing short term finance. Now
banks have become primary source of financing working capital of business
organizations. In India, primary source of financing working capital are bank credit and
trade credit.

Bank credit is primary institutional source of finance. The borrower approaches a
bank to obtain bank credit. For this, he has to submit necessary supporting data. The
bank sanctions amount of credit on the basis of margin requirement. Margin means
percentage' of value of asset that is offered as security of borrower. The margin is laid
down by RBI. It is changed from time to time as per the requirement of credit policy.

Banks have introduced many innovative schemes for disbursement of credit.
Providing loans to business is one of the primary functions of bank. Banks are
depositories of the cash resource of community, a part of it is made available for loans.
Banks lend money in different ways -

Types of Bank credit

1. Overdraft : A company having current account with a bank, is allowed overdraft
facility. The borrower can withdraw the funds, as and when needed. He is allowed to
overdraw on his current account, up to the credit limit which is sactioned by the bank.
Within this stipulated limit any number of drawings are permitted. Repayments can be
made whenever required during the time period. The interest is determined on the
basis of actual amount overdrawn.

2. Cash Credit : It is also an important and popular form of financial aid. This form of
credit is operated in the same manner as overdraft facility. The borrower can withdraw
amount from his current account up to a stipulated limit based on security margin. Cash
Credit is given against pledge or hypothecation of goods or by providing alternative
securities. Interest is charged on outstanding amount borrowed and not on the credit
limit sanctioned.

3. Cash loans (Loan arrangement) : Under this the total amount of loan is credited by
bank to the borrower's account. Interest is payable on entire amount sactioned as loan.
If the loan is repaid in installments, interest is payable on actual balance outstanding.

(G) Trade credit
No business can be run without 'credit'. It is considered as soul of business.
Trade credit financing is common to all businesses. It is a short term financing to
business.

Manufactures, wholesalers and suppliers of goods or materials are called `Trade
creditors'. They sell tangible goods to other business concerns on the basis of future
payment i.e. deferred payment. Credit is extended by these business concerns with an
intention to increase their sales. These business firms extent credit, also because of the
custom that has been built up over time. Such credit is not cash-loan. It results from a
sale of goods/services, which have to be paid some time after the sale takes place.

In short, `trade credit' is said to be granted when goods are delivered by
supplier to a customer, in advance of payment.

In distributive trade this kind of credit has great significance. The small retailers,
to a large extent rely on obtaining trade credit from their suppliers. It is a cheap
method of financing. It is the easy kind of credit which can be obtained without signing
any debt instrument.
Suppliers sell goods and willingly allow 30 days or more for a bill to be paid.
Even they offer discounts, if bills are cleared within a short period such as 10 days 15
days, etc.
There are several advantages attached to Trade Credit. Some of them are as
follows:

1. Trade credit is the cheapest and easiest method of raising short term finance.

2. It does not require any formal and written agreement.

3. It is readily available at any time.

4. It is free of cost source of financing.

5. The terms of credit are not rigid.

Compare trade credit with bank credit and discuss with the teacher.

(H) Discounting of Bill of Exchange :

Discounting of bill is relatively of recent origin in India. Reserve Bank of India has
introduced `New Bill Market Scheme' in 1970. According to this, bank credit is being
made available through discounting of bill by banks. In short, under the scheme, RBI
has considered use of bill as an instrument of credit.

Meaning of bill of exchange :

Negotiable Instrument Act 1881, defines,

"A bill of exchange is an instrument in writing containing an unconditional order signed
by maker, directing a certain person to pay a certain sum of money only to or to the
order of certain person or to the bearer of instrument."

The above definition reveals important features of a bill of exchange :
1. It is an unconditional order.
2. It contains name of person to whom it is payable.
3. It specifies amount to be paid.
4. It is in writing.
5. It is dated and signed.
In brief, the seller gets a definite promise in writing from buyer, for paying the
amount on a specific date. This written promise is known as Bill of Exchange.


What is discounting of bill of exchange?
The drawer of the bill (i.e. seller) can receive money from drawee (i.e. buyer) on
the due date or after the due date. Drawer can receive money before the due date by
discounting the bill with a bank. This is nothing but selling the bill to the bank Drawer
gets money immediately from bank against the bill. The bank gives money to drawer
less than the face value of the bill. The amount received less is called `discount'. It is
the interest charged by bank. The bank deposits money into the account of drawer. On
the due date bank collects money from drawee against the bill.

Thus, bills of exchange are trade bills. These written promises are common in
business world. They are accepted by banks and cash is advanced against them.

(I) Global Depository Receipt (GDR), and American Depository Receipt (ADR)

Every public company issues shares. These shares are listed and traded on
various share markets. Companies in India issue shares which are traded on Indian
share markets like BSE ( Bombay Stock Exchange) and NSE (National Stock Exchange)
etc.

With adoption of free economic policy and due to globalisation, shares of some
of the Indian companies are also listed and traded on foreign stock exchanges like
NYSE ( New York Stock Exchange) or NASDAQ (National Association of Securities
Dealers Automated Quotation.).

To list shares on stock exchanges, a company has to comply with policies of
those stock exchanges. These policies are much more different from the policies of
Indian stock exchange. Therefore, those Indian companies which can not list their
shares directly on foreign stock exchange, get listed on these stock exchanges indirectly
using GDR and ADR.

Indian companies raise equity capital in international market through GDR and
ADR It is dollar/ Euro denominated instrument traded on stock exchanges of USA and
Europe. Company issues shares to an intermediary called `depository.' Bank of New
York, City group etc. act as Foreign Depository Banks. The Depository banks issue GDRs
Or ADRs to investors against these shares. Each `Depository Receipt' is having fixed
number of shares. These `Depository Receipts' are then sold to people of a foreign
country. The Depository Receipts are listed on the stock exchanges. These Depository
Receipts are traded like ordinary shares. In simple words, the depository bank stores
the shares on behalf of the receipt-holder.
Both ADR and GDR are depository receipts. They represent a claim on underlying
shares. The only difference is the location where they are traded. If the Depository
Receipt is traded in U.S.A, it is called `American depository Receipt' (ADR). If the
Depository Receipt is traded in a country other than USA, it is called `Global Depository
receipt (GDR).'

ADR and GDR are means of investment for NRI (Non-Resident Indians) and
foreign nationals, wanting to invest money in India. By purchasing ADR or GDR, they,
can invest directly in Indian companies. NRI and foreigners can buy Depository Receipts
using their regular equity trading account. The companies pay dividend in home
currency to depositories and depositories convert it into the currency of investor and
pays dividend.

List of Indian companies having ADR and GDR

Name of company ADR GDR
1. Bajaj Auto Ltd. No Yes
2. HDFC Yes Yes
3. ICICI Bank Yes Yes
4. Infosys Technologies Yes Yes
5. ITC No Yes
6. L & T No Yes
7. MTNL Yes Yes
8. Hindalco No Yes
9. Ranbaxy Laboratories No Yes
10. Tata Motors Yes No
11. State Bank of India No Yes
12. VSNL Yes No
13. WIPRO Yes Yes

Advantages
1. GDR and ADR allow investors to invest in foreign companies without worrying about
foreign trading practices, different laws, accounting rules, etc.
2. They offer voting rights to the holders of Depository Receipts.
3. The other benefits are easier trading and payment of dividend in the native currency.
4. The major benefit of Depository Receipts is that the institutional investors can buy
them.
5. Depository Receipts also overcome limits or restrictions on foreign ownership that may
be imposed by the country of issuer.
6. They eliminate local taxes or transfer taxes that would be due, if the company shares
are bought or sold directly
7. The main benefit to the company is, to increase coverage in new markets, large and
more diverse shareholders base and ability to raise more capital in international
markets.

The exchanges on which GDR is traded are as follows
1. London Stock Exchange
2. Luxin Bourg Stock Exchange
3. NASDAQ, Dubai.
4. Singapore Stock Exchange
5. Hong Kong Stock Exchange.

SUMMARY

Finance may be defined as `study of money management'. It holds the key to all
activities of an organization.

The various sources of finance available can be divided as long term and short term
finance, as well as owned capital and borrowed capital.

There are various methods of raising finance viz shares, debentures, bonds, retained
profits, public deposits, trade credit, GDR, ADR, etc. Share is a small unit of the share
capital of a company.

Equity shares do not enjoy preference for dividend and do not have priority for payment
of capital at the time of winding up of company.

Preference shares have prior right to receive fixed rate of dividend and return capital in
the event of winding up of company.

The debt acknowledged by a company by issuing debenture certificate is called
debenture. Bond is an instrument issued by Government or business firm as an
evidence of debt. Retained profit is sum total of accumulated profit which are
reinvested in the business. Public deposit is a sort loan accepted by company for short
term period ranging from 6 months to 36 months.

Company can raise loans from banks in the form of overdraft, cash credit, cash loans,
etc. Government has set up financial institutions for providing financial aid to companies
etc. Trade credit is a credit extended by manufacturers, suppliers etc. to customers.

Bill of exchange is a trade bill which is accepted by bank and cash is advanced against
it. ADR and GDR are depository receipts through which Indian companies raise equity
capital in international market.

Key Terms
Finance : Study of money management
Share : Small unit of share capital.
Equity Shares : Shares other than preference shares.
Preference shares : Preferential right to receive fixed rate of dividend and return of capital
Debenture : Evidence of debt / debt security.
Bond : Debt security.
Retained earning : Accumulated profit retained by company.
Public deposit : Unsecured short-term loan.
Bank credit : Loan sactioned by bank.
Trade credit : Sale of goods on the basis of deferred payment.
Bill of exchange : Trade bill.
Depository Receipt : Bank stores the shares on behalf of receipt holder.

EXERCISE

Q.1 A Select the correct answer from the possible choices given below and rewrite
the statements.

1. The .............. is considered as supreme controlling factor in business.
a) finance b) material c) machinery

2. A business firm requires long term finance for meeting ............... captial needs.
a) working b) fixed c) circulating

3. A ............... is indivisible unit of share capital.
a) debenture b) share c) bond

4. A person who purchases. shares of a company is known as ............... of the company.
a) shareholder b) bond holder c) creditor

5. A shareholder is entitled to receive ........... as return on investment.
a) dividend b) interest c) discount

6. A company can not exist without ............... shares.
a) preference b) bonus c) equity

7. The ............... shares bear ultimate risk associated with the ownership
a) equity b) preference c) deferred

8. Equity shares are paid dividend at ............... rate.
a) fluctuating b) fixed c) high

9. Bonus shares are issued as gift to ............... shareholders.
a) equity b) preference c) deferred

10. Preference shares carry dividend at ............... rate.
a) fixed b) fluctuating c) lower

11. Accumulated dividend is paid to ............... preference shares.
a) redeemable b) cumulative c) convertible

12. The holder of ............... preference shares have right to convert their shares into
equity shares.
a) cumulative b) convertible c) redeemable.

13. Retained earnings are ............... source of financing.
a) internal b) external c) additional
14. Debentureholders are ............... of the company.
a) creditor b) owner c) supplier

15. Debentures are issued to raise .............. capital.
a) borrowed b) owned c) internal

16. Debentureholders get fixed rate of ............... as return on their investment.
a) interest b) dividend c) discount

17. Debentures are secured through ...............
a) agreement b) contract c) Trust Deed

18. Convertible debentures are converted into ............... after a specified period.
a) equity shares b) bonds c) deposits

19. The holder of the bond is ............... of the institution.
a) owner b) creditor c) secretary

20. Company can accept deposits from public, minimum for .............. months.
a) Six b) Nine c) Twelve

21. Company can accept deposits from public, maximum for ............... months
a) 12 b) 24 c) 36

22. Overdraft facility is allowed to ............... account holder.
a) current b) saving c) recurring

23. Small retailers rely on .............. credit from their suppliers.
a) cash b) trade c) bank

24. A Depository receipt traded in ............. is called `American Depository Receipt'.
a) London b) Japan c) USA

25. The main benefit of `Depository Receipt' is ability to raise more capital in ..............
market.
a) national b) local c) international

Q.1 B Match the pairs.
Group A Group B
a) Equity share capital
b) Debentureholder
c) Retained profit
d) Public deposit
e) Overdraft facility
1) Maximum 5 years
2) Owner of the company
3) Redeemable capital
4) Permanent capital
5) Creditor of the company
6) Current Account
7) Maximum 3 years
8) Capitalisation of profit
9) Saving Account
10) Distributor of profit


Q.1 C Write a word or a term or a phrase which can substitute each of the following
statements .
1. Name the shareholders who participate in the management of company.
2. The value of share which is written on the share certificate and mentioned in the
Memorandum of Association.
3. The value of share which is determined by demand and supply forces in the share
market.
4. Name the shareholders who are `residual claimants' against the assets and income.
5. Name the shareholders who are real masters of the company.
6. Type of the shares who have preferential right over equity shares in respect of dividend
and return of capital.
7. Type of shares which can be redeemed after a certain period of time.
8. The policy of using undistributed profit into business.
9. A bond on which no interest is paid but issued at discount.
10. Name the bond, on which the rate of interest remains constant through out the life of
the bond.
11. Money raised by company form public for minimum 6 months to maximum, 3 years.
12. Credit extended by suppliers with an intention to increase their sales.
13. A definite promise in writing from buyer for paying the amount on a specific date.
14. Dollar denominated instrument traded in stock exchange of USA.
15. The `Depository Receipt' traded in the country other than USA.

Q.2 Distinguish between the following.
1. Equity shares and Preference shares
2. Shares and Debentures

Q.3 Write notes on.
1. Features of equity shares
2. Features of preference shares
3. Types of debentures
4. Public deposits
5. Retained profits
6. Types of bank credit
7. Trade credit
8. Global Depository Receipt
9. Need and importance of financial institutions
10. Discounting of Bill of exchange
Q.4 State, with reasons, whether the following statements are True or False.
1. Equity shareholders are real owners and controllers of company.
2. Preference shareholders do not enjoy normal voting rights.
3. Debentures can be secured with some property of the company.
4. Retained earning is difficult and costly method of raising capital.
5. The bond holders are owners of the company.
6. Public deposit is good source for long term financing.
7. Providing loan to business is primary function of bank:
8. Financial institutions do not have any role in financing industrial firms.

Q.5 Answer in brief.
1. What is share? State the features of shares.
2. State the features of debentures.
3. What is bond? State various types of bonds.
4. What are the determinants of retained earnings?

Q.6 Answer the following questions.
1. What is equity share ? State the features of equity shares.
2. Define preference shares. State various types of preference shares.
3. What is debenture? State features of debentures
4. Define debenture. State and explain types of debentures.
Labels: SOURCES OF BUSINESS FINANCE XII COMMERCE SP NEW SYLLABUS