Tuesday, December 7, 2021 1

SIGNIFICANCE OF FINANCE
 It is the life blood of the business
 It helps the business to carry on its business
operations smoothly
 It is required to acquire fixed assets
 It determines the scale of production
 It helps the firm to maintain the flow of production
 It bridges the gap between production and sales
 It helps to face recession, trade cycles and other crisis
 It helps the firm to replace its fixed assets in time
 It helps to helps the firm to meet its liabilities in time
Tuesday, December 7, 2021 2
 Capital requirement for different
forms of business
 For Sole Trader : Proprietor’s brings own capital; As the
scope of the business is less he is the only source to raise
finance. The liability of the proprietor is unlimited
 For Partnership firm: The capital base of the firm is
bigger than that of a sole trader business. Here the risk is
shared.
 For Joint Stock Company: Source for the capital is very
much large. Here with the scope of public issue in the form
of shares and debentures apart from these joint stock
company can go for loans from from banks for short term
plans.
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Sources of Finances of a company
On the basis of Time (period of use)
Long Term Capital
Medium Term Capital
Short Term Capital
On the basis of purpose of use
Fixed or Permanent Capital
Working or Revolving or Circulating Capital
On the basis of sources of finance
External Sources of finance
Internal Sources of finance
On the basis of risk
Owned or Risk Capital
Borrowed Capital
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 On the basis of Time (Period of Use)
As discussed earlier capital is classified into three
categories.
 Long-Term Capital : It is required by the business
house for a long period of time. (5 to 20 years). It is
essential for permanent investments in capital
assets. The sources of long-term finance are as
follows:
Issue of Shares
Issues of Debentures
Long-Term loans from Banks and financial institutions
Accepting Public Deposits
Ploughing back of profits (or retained earnings)

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Medium Term Capital : It is required by a
business house for long period of time I.e from
one to five years. This is usually required for
Permanent Working Capital
Normal Extensions and
Replacement of Assets
The main sources of medium term capital are
Issues of Preference Shares
Issues of Debentures
Receiving Public Deposits
Loans from Financial Institutions
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 Short Term Capital : This is maintained by the business house
for a period of less than one year. It is necessary to run the
business very smoothly, efficiently and economically. The
sources of short term finances are
Trade Credit
Bank Overdraft
Short Term borrowings from Banks and Financial Institutions
Bills of Exchange
Customers’ Advances
Borrowings from Subsidiaries
Installment Credit
Trade Credit
Commercial Banks
 Loans and Advances
 Cash Credits
 Bank Overdrafts
 Discounting Bills of Exchange
 Factoring (Accounts Receivable Financing)

Tuesday, December 7, 2021 7

Capital Planning

 Cost of promotion
 Cost of financing
 Cost of fixed assets
 Cost of intangible assets
 Cost of current assets
 Cost of developing business

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Factors to be considered for devising the
capital structure
 Nature of business
 Size of business
 Cash inflows
 Cost of raising capital
 Period of finance
 Flexibility of capital structure
 Trading on equity
 Control of the company
 Needs of Investors
 Capital market conditions
 Legal requirements
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Fixed Capital : It is permanently locked in the Fixed assets of
the business for a long period. The amount of fixed capital
varies from industry to industry. Thus fixed capital is required
for: -
(I) Establishing a new enterprise
(II) Expanding the existing enterprise
(III) Diversifying the existing enterprise
(IV) Remodeling the present Equipment.

Now let us see the factors that determine the amount of fixed
capital :

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Factors Determining Fixed Capital
Nature of the Business
Size of the business
Nature of the products
Method of Production
Diversity of production Lines
Technique of Production
Volume of Production
Sources of Raising Capital
Mode of acquiring fixed assets
Intangible Assets
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Working Capital
This is also known as Circulating or Revolving Capital. The
equation of working capital is

Working Capital = Current Assets – Current Liabilities

Classification of Working Capital

Permanent Working Capital Temporary Working Capital

Initial Regular Seasonal Special

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Working Capital Cycle

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Importance of Working Capital
 Timely Payment of Dues
 Ensures solvency of business
 High credit-worthiness
 Timely payment of dividends
 Advantage of cash-discounts
 Meeting daily operational expenses
 Possibility of acquiring loans
 Enhancing the morale of the employees
 Executing special orders
 Availing better marketing opportunities
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 Factors determining the amount of Working Capital
 Nature of Business
 Size of the business
 Manufacturing cycle
 Business Cycles
 Length of processing period
 Rapidity of Turnover
 Terms of Purchase and Sale
 Volume of Production
 Price level changes
 Credit policy
 Growth and expansion policies
 Operating efficiency
 Profit margin and profit appropriation
 Convertibility of current assets into cash
 Goodwill of the business

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On the basis of Sources of Finance
On the basis of sources of
finances capital is classified
into two categories. They are :-
External Sources
Internal Sources

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On the basis of Sources of Finance
External Sources : Sources
from outside the business. This
is of two kinds. They are
Owned Capital
Borrowed Capital

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External Sources – Owned Capital

The capital which is owned by

the company is known as
owned capital. They are :
New Issue of Equity Shares
Right Shares
Bonus Shares

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External Sources – Borrowed Capital
The capital which is borrowed from
outsiders by the company is known
as owned capital. They are :
Preference Shares
Debentures
Financial Institutions
Others

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Capital – Several Senses
 Authorised or Nominal Capital
 Issued Capital – Part of Authorised issued to public
 Subscribed Capital – part of the issued which the public apply
for purchase
 Called up Capital – Part of subscribed which is called up by the
company
 Paid up capital – part of called up which is paid up by the
public
 Reserve Capital – uncalled portion of the subscribed capital,
which is collected at the time of liquidation
 Calls in arrear – part of called up capital which is not paid by
the public
 Calls in advance – part of the subscribed capital which is not
called
Tuesday, Decemberbut
7, 2021 paid by the public. 20
Capital – Equity Shares
 The investors are treated as owners
 The degree of risk in investing is very high
 The investors enjoy voting rights
 The investors can participate in management
 The rate of dividend fluctuates with profits
 The nominal value of shares is generally low
 The arrears of dividend can not accumulate
 The shares can not be converted into any form
 The shares are not redeemable
 The refund of capital is done after giving preference to preference share holders
are paid
 The dividend is paid after the interest of the preference share holders is attended
 The investors that invest in these shares are treated as adventurous investors
 The market value of these shares do fluctuate many times
 This is also known as Risk Capital.

Tuesday, December 7, 2021 21

Equity Shares – Merits
Point of View of Share holders Point view of the Company

High Dividends Permanent Capital

Voting Rights No mortgage of assets

Appreciation in the value of shares No fixed obligation to pay dividend

High Returns in boom periods Makes a company financially sound

Possibility of getting bonus shares Diffusion of risk

High liquidity of invested funds Capacity to raise further capital

Profitable during inflation

Tuesday, December 7, 2021 22

Equity Shares – Demerits
Point of View of Share holders Point view of the Company

Uncertainty of Earnings High Cost of Finance

High Risk Danger of Over-Capitalization
Less preferred by cautious Danger of manipulation of
investors dividends

Inability to participate in the Manipulation by a powerful

management group

Less refund of capital during Concentration of power in a few

liquidation hands

No control over dividend

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Owned Capital – Bonus Shares
 Shares which are issued free of cost to the existing shareholders are
called as Bonus shares. Sometimes, when a company is not in a
position to pay dividend due to inadequate liquid resources, it can issue
bonus shares. Fully paid bonus shares can be issued at par or at a
premium. A company can also issue partly paid bonus shares to make
uncalled capital being called-up. Issue of bonus shares boosts the image
of the company. Bonus shares are also popularly known as
Capitalisation of Reserves. The company has got the same obligations
to bonus shares, as it has to equity shares. Bonus shares can be issued
from the following funds :
 Profit and Loss Account (Credit Balance)
 General Reserve of Reserve Fund
 Capital Reserves and Profit
 Share Premium Account
 Capital Redemption Reserve Account
 Balance in Sinking Fund for redemption of debentures or other liabilities.

Tuesday, December 7, 2021 24

Owned Capital – Right Shares
Shares which are issued after the original
issue of equity shares are known as Right
Shares. These are issued when a public
limited company wants to increase its share
capital. These are to be issued first to the
existing equity share holders on a pro rata
basis. When they reject to accept the same
these could be offered to non-members.
The company has got the same obligation
to right shares , as it has to equity shares.
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Owned Capital – Deferred Shares
 These shares participate in the profits of the company only
after all the claims of all other shareholders have been met
(both equity and preference). These are generally issued to
the promoters of the company. That is the reason these are
also called as “Founders Shares”. The denomination of
these shares is very low and are purchase by those who
want to keep control over the managerial affairs of the
company. Deferred shares have voting right which are very
significant in controlling the affairs of the company. A public
limited company is not supposed to issue these shares. Any
how no private companies also are not issuing these shares
these days.

Tuesday, December 7, 2021 26

Capital – External Sources – Borrowed
Capital - Preference Shares
 The rate of dividend is fixed
 The investors do not enjoy voting rights
 The degree of risk in investing these shares is low
 The investors are treated as creditors
 The investors can not participate in the management of the
company
 The nominal value of these shares is generally high
 The arrears of the may accumulate
 These shares can be converted into Equity shares
 At the time of redemption preference share holders are given
first importance
 At the time of payment of dividend preference share holders
are given first importance
 Generally safe players do invest in these shares
 The market value of these shares do not alter
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Types of Preference Shares
Cumulative
Non-Cumulative
Redeemable
Irredeemable
Participating
Non-participating
Convertible
Non-convertible
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Preference Shares – Merits
Point of View of Share holders
Right to receive dividend
Repayment of Capital
Fixed Rate of dividend
Less Risks
Cumulative Dividend
Right to be redeemed
Tuesday, December 7, 2021
Point view of the Company
Capital without charge
No loss of control
Cheaper modes of finance
Cushion to the Debenture
Holders
Strengthening the financial
position
Long maturity
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Preference Shares – Demerits
Point of View of Share holders
Restricted Voting Rights
Deprived of Capital
Appreciation
Deprived of increased rate
of dividend
Unattractive during boom
period
Tuesday, December 7, 2021
Point view of the Company
Permanent Burden
Costly method of raising
finance
Compliance with certain
conditions
Paves the way for
insolvency of the company
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Transactions - Shares
Forfeiture of Shares
Surrender of Shares
Transmission of Shares
Underwriting of Shares
Converting Shares into
Stock
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Shares Vs Stock
Basis of Distinction
Nominal Value
Paid-Up
Distinctive Number
Transfer in fraction
Time of issue
Direct issue to public
Nature of issuing company
Denomination
Tuesday, December 7, 2021
Shares
Has a nominal or face value
It could be partly paid up or fully
paid up
Always assigned a distinct number
Can not be transferred
Should be issued at the inception
of the company
Can be offered directly to the
public for subscription
Can be issued by an unlimited
company
Has always a fixed denomination
Stock
No face value. It can be of any
denomination
Always fully paid up
Does not bear a number
Can be transferred
Should not be issued at the time of
inception
Can not be directly issued to the
public
Only a limited company can
convert its fully paid-up shares into
stock
Can be of any denomination
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Equity Shares Vs Preference Shares
Basis of Distinction Equity Shares Preference Shares

Rate of Dividend Fluctuates with profits Fixed rate of dividend

Voting Rights Enjoy Voting Rights Do not enjoy voting rights

Status of investors Owners Creditors

Participation in management Can participate Cannot participate

Nominal value of shares Generally Low Generally High

Arrears of dividend Can not accumulate May accumulate

Convertibility of shares Not convertible May be convertible

Redeemability of shares Not redeemable Redeemable

Refund of capital After preference shares are paid Priority over equity shares

Right to receive dividend After preference shares are paid Priority over equity shares

Appeal to the investors Adventurous investors Conservative investors

Market value of shares Do fluctuate Do not alter

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Capital – External Sources –
Borrowed Capital - Debentures
 The nature of investment is it is a borrowed fund
 The investors are treated as creditors
 The reward for the investment is the interest
 The assets are the security for the investment made
 Debenture holders do not enjoy voting rights
 The return on investment is fixed
 Debentures are redeemable after a certain period
 The risk in investment is low
 Debenture holders have no control over the affairs of the company
 Priority is given to debenture holders at the time of payment of interest
and liquidation
 There are no restrictions on issue of debentures
 Debentures could be converted into equity shares after certain time
 Payment of interest on debentures is a charge against profit.

Tuesday, December 7, 2021 34

Types of Debentures
Registered
Unregistered or Bearer
Secured or Mortgaged
Unsecured or Simple
Redeemable
Irredeemable
Convertible
Non-Convertible
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Debentures – Merits

Point of View of Debenture Point view of the Company

Holders
Fixed Returns and better Income Tax relief
security
Stable Prices Economy on financing
Safety of Investment Trading on Equity

Preferred by Cautious Flexibility

Investors

Tuesday, December 7, 2021 36

Debentures – Demerits
Point of View of Share holders Point view of the Company
No Voting Rights Permanent Burden of interest
High Unit Price Charge on Assets

Unattractive terms of issue Reduction in Dividend

Unattractive for new- Heavy Stamp Duty

investors

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Shares Vs Debentures

Basis of Distinction Shares Debentures

Nature of investment Owned Capital Borrowed Fund

Status of Holders Owners Creditors

Reward for investment Dividend Interest

Security of Investment No charge on Assets Charge on Assets

Voting Rights of investors Have voting rights Do not have voting rights

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Shares Vs Debentures
Basis of Distinction Shares Debentures
Return from Investment Fluctuates Fixed

Not redeemable (except

Redeemable after a certain
Redemption redeemable preference
period
shares)

Risk associated with

High risk Low risk
Investment
Priority on refund of
No priority Prior to shareholders
capital

Restriction on issue Certain restrictions No restrictions

Convertibility Not convertible May be convertible

Charge/Appropriation of
Appropriation of profit Charge against profit
Profit
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Capital – Internal Sources – Retained
Earnings
The balance of profits after income tax, interest on
debentures, payment of dividends and transfer of
funds to different Reserves is known as Retained
Earnings.
When this amount is accumulated for a number of
years this is known as Retained Earnings
This method of financing a company is also known
as “Self-Financing”.

Tuesday, December 7, 2021 40

Retained Earnings
Merits and Demerits
MERITS DEMERITS
Interest and Obligation Free Financial Danger of Over Capitalization
Assistance
Funds without charge on assets Misuse of funds

Safe Investment Indulge in speculation

Safety from business cycles Dissatisfaction among shareholders

Appreciation of value of shares

Convenient source of finance

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Capital – External Sources – Public Deposits
 These are invited only by Public Limited Companies
 The minimum period is for 6 months and the maximum period
is for 3 years
 These are an effective way of raising Medium and Short term
finance
 There is no need to go mortgaging of assets to acquire these
deposits
 This is a direct method of channelising the public money into
industrial activities
 This is less expensive compared to other modes of raising
finance
 This is a quick method of current financing
 These are also known as “fair weather friends”
Tuesday, December 7, 2021 42
Public Deposits
Merits and Demerits
MERITS DEMERITS

Economical source of raising Unsuitable for new concerns

finance
No legal formality Possibility of cheating

Higher return to investors Uncertainty of getting deposits

Higher distribution of dividend Unsuitable of long-term financing

Loans without mortgage of assets Encouraging speculation

No-interference in the management Unsecured deposit

Elasticity in the capital structure Loss of credit worthiness

Tuesday, December 7, 2021 Hampering the growth of capital
43

markets
 Short Term Capital
This is maintained by the business house for a period of less than
one year. It is necessary to run the business very smoothly,
efficiently and economically. The sources of short term finances
are
Trade Credit
Bank Overdraft
Short Term borrowings from Banks and
Financial Institutions
Bills of Exchange
Customers’ Advances
Borrowings from Subsidiaries
Installment Credit
Trade Credit
Tuesday, December 7, 2021 44
Short Term Capital
Commercial Banks
Loans and Advances
Cash Credits
Bank Overdrafts
Discounting Bills of Exchange
Factoring (Accounts Receivable Financing)
Indigenous Bankers
Accrual Accounts
Commercial Papers
Tuesday, December 7, 2021 45
Factors to be considered in determining the
Capital Structure
Nature of the business
Size of the business
Cost or raising capital
Elasticity of capital structure
Control of the company
Financial solvency
Cash inflows
Trading on equity
Needs of potential investors
Conditions of capital market
Legal requirements
Period of finance
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