Sources of Finance

As you are aware finance is the life blood of business. It is of vital significance for modern business
which requires huge capital. Funds required for a business may be classified as long term and short term.
To meet out these requirements, funds need to be raised from various sources. Some sources like issue of
shares and debentures provide money for a longer period. These are therefore, known as sources of long-
term finance. On the other hand sources like trade credit, cash credit, overdraft, bank loan etc. which
make money available for a shorter period of time are called sources of short-term finance.

Long Term Finance – Its meaning and purpose

A business requires funds to purchase fixed assets like land and building, plant and machinery, furniture
etc. These assets may be regarded as the foundation of a business. The capital required for these assets is
called fixed capital. A part of the working capital is also of a permanent nature. Funds required for this
part of the working capital and for fixed capital is called long term finance. Long term finance is required
for the following purposes: To Finance fixed assets, To finance the permanent part of working capital &
To finance growth and expansion of business.

Sources of long term finance

The main sources of long term finance are as follows:

1. Shares:

These are issued to the general public. These may be of two types:

(i) Equity
(ii) (ii) Preference.

The holders of shares are the owners of the business.

Equity Shares:

Equity shares are shares which do not enjoy any preferential right in the matter of payment of dividend or
repayment of capital. The equity shareholder gets dividend only after the payment of dividends to the
preference shares. There is no fixed rate of dividend for equity shareholders. The rate of dividend depends
upon the surplus profits. In case of winding up of a company, the equity share capital is refunded only
after refunding the preference share capital. Equity shareholders have the right to take part in the
management of the company. However, equity shares also carry more risk.

Preference Shares :

Preference Shares are the shares which carry preferential rights over the equity shares. These rights are (a)
receiving dividends at a fixed rate, (b) getting back the capital in case the company is wound-up.
Investment in these shares are safe, and a preference shareholder also gets dividend regularly.
2. Debentures:

These are also issued to the general public. The holders of debentures are the creditors of the company.
Whenever a company wants to borrow a large amount of fund for a long but fixed period, it can borrow
from the general public by issuing loan certificates called Debentures. The total amount to be borrowed is
divided into units of fixed amount say of Rs.100 each. These units are called Debentures. These are
offered to the public to subscribe in the same manner as is done in the case of shares. A debenture is
issued under the common seal of the company. It is a written acknowledgement of money borrowed. It
specifies the terms and conditions, such as rate of interest, time repayment, security offered, etc.

Debentures may be classified as:

a) Redeemable Debentures and Irredeemable Debentures

b) Convertible Debentures and Non-convertible Debentures.

3. Public Deposits :

General public also like to deposit their savings with a popular and well established company which can
pay interest periodically and pay-back the deposit when due. Like an individual, companies also set aside
a part of their profits to meet future requirements of capital. Companies keep these savings in various
accounts such as General Reserve, Debenture Redemption Reserve and Dividend Equalization Reserve
etc. These reserves can be used to meet long term financial requirements.

4. Retained earnings:

Like an individual, companies also set aside a part of their profits to meet future requirements of capital.
Companies keep these savings in various accounts such as General Reserve, Debenture Redemption
Reserve and Dividend Equalization Reserve etc. These reserves can be used to meet long term financial
requirements.

5. Public Deposits

It is a very old source of finance in India. When modern banks were not
there, people used to deposit their savings with business concerns of
good repute. Even today it is a very popular and convenient method of
raising medium term finance. The period for which business undertakings
accept public deposits ranges between six months to three years.

6. Term loans from banks:

Many industrial development banks, cooperative banks and commercial banks grant medium term loans
for a period of three to five years.

6. Loan from financial institutions:

There are many specialised financial institutions established by the Central and State governments which
give long term loans at reasonable rate of interest. Some of these institutions are: Industrial Finance
Corporation of India ( IFCI), Industrial Development Bank of India (IDBI), Industrial Credit and
Investment Corporation of India (ICICI), Unit Trust of India ( UTI ), State Finance Corporations etc.

Short-term Finance – Its meaning and purpose

After establishment of a business, funds are required to meet its day to day expenses. For example raw
materials must be purchased at regular intervals, workers must be paid wages regularly, water and power
charges have to be paid regularly. Thus there is a continuous necessity of liquid cash to be available for
meeting these expenses. For financing such requirements short-term funds are needed. The availability of
short-term funds is essential. Inadequacy of short-term funds may even lead to closure of business.

Sources of Short-term Finance

1. Trade Credit
Trade credit refers to credit granted to manufactures and traders by the suppliers of raw material, finished
goods, components, etc. Usually business enterprises buy supplies on a 30 to 90 days credit. This means
that the goods are delivered but payments are not made until the expiry of period of credit. This type of
credit does not make the funds available in cash but it facilitates purchases without making immediate
payment. This is quite a popular source of finance.

2. Bank Credit
Commercial banks grant short-term finance to business firms which is known as bank credit. When bank
credit is granted, the borrower gets a right to draw the amount of credit at one time or in installments as
and when needed. Bank credit may be granted by way of loans, cash credit, overdraft and discounted
bills.

(i) Loans
When a certain amount is advanced by a bank repayable after a specified period, it is known as bank loan.
Such advance is credited to a separate loan account and the borrower has to pay interest on the whole
amount of loan irrespective of the amount of loan actually drawn. Usually loans are granted against
security of assets.

(ii) Cash Credit

It is an arrangement whereby banks allow the borrower to withdraw money upto a specified limit. This
limit is known as cash credit limit. Initially this limit is granted for one year. This limit can be extended
after review for another year. However, if the borrower still desires to continue the limit, it must be
renewed after three years. Rate of interest varies depending upon the amount of limit. Banks ask for
collateral security for the grant of cash credit. In this arrangement, the borrower can draw, repay and
again draw the amount within the sanctioned limit. Interest is charged only on the amount actually
withdrawn and not on the amount of entire limit.

(iii) Overdraft
When a bank allows its depositors or account holders to withdraw money in excess of the balance in his
account upto a specified limit, it is known as overdraft facility. This limit is granted purely on the basis of
credit-worthiness of the borrower. Banks generally give the limit upto Rs.20,000. In this system, the
borrower has to show a positive balance in his account on the last friday of every month. Interest is
charged only on the overdrawn money. Rate of interest in case of overdraft is less than the rate charged
under cash credit.
(iv) Discounting of Bill
Banks also advance money by discounting bills of exchange, promissory notes and hundies. When these
documents are presented before the bank for discounting, banks credit the amount to customer’s account
after deducting discount. The amount of discount is equal to the amount of interest for the period of bill.
This parthas been discussed in detail later on in this chapter.

3. Customers’ Advances
Sometimes businessmen insist on their customers to make some advance payment. It is generally asked
when the value of order is quite large or things ordered are very costly. Customers’ advance
Represents a part of the payment towards price on the product which will be delivered at a later date.
Customers generally agree to make advances when such goods are not easily available in the market or
there is an urgent need of goods. A firm can meet its short-term requirements with the help of customers’
advances.

4. Installment credit
Installment credit is now-a-days a popular source of finance for consumer goods like television,
refrigerators as well as for industrial goods. You might be aware of this system. Only a small amount of
money is paid at the time of delivery of such articles. The balance is paid in a number of installments. The
supplier charges interest for extending credit. The amount of interest is included while deciding on the
amount of installment. Another comparable system is the hire purchase system under which the purchaser
becomes owner of the goods after the payment of last installment. Sometimes commercial banks also
grant installment credit if they have suitable arrangements with the suppliers.

5. Loans from Co-operative Banks

Co-operative banks are a good source to procure short-term finance. Such banks have been established at
local, district and state levels. District Cooperative Banks are the federation of primary credit societies.
The State Cooperative Bank finances and controls the District Cooperative Banks in the state. They are
also governed by Reserve Bank of India regulations. Some of these banks like the Vaish Co-operative
Bank was initially established as a co-operative society and later converted into a bank. These banks grant
loans for personal as well as business purposes. Membership is the primary condition for securing loan.
The functions of these banks are largely comparable to the functions of commercial banks.