CH – 8 SOURCE OF BUSINESS

Retained Earnings

Retained earnings refer to the portion of a company’s net profits that is not distributed as dividends but kept
within the business for future use. It serves as an internal source of financing, also known as self-financing or
ploughing back of profits. The amount available for retention depends on factors like net profits, dividend
policy, and the company’s age.

Merits of Retained Earnings:

1. Permanent source of funds for the organization.

2. No explicit cost such as interest or dividend payments.
3. Provides operational flexibility and independence.
4. Helps absorb unexpected losses.
5. Can increase the market value of equity shares.

Limitations of Retained Earnings:

1. May cause shareholder dissatisfaction due to lower dividends.

2. Uncertain source of funds as business profits fluctuate.
3. Opportunity cost is often overlooked, leading to inefficient fund utilization.

Trade Credit

Trade credit is a short-term financing method where one trader extends credit to another for purchasing goods
and services without immediate payment. It appears as "sundry creditors" or "accounts payable" in the buyer’s
records. The availability and terms of trade credit depend on factors like the buyer’s reputation, seller’s financial
position, purchase volume, and past payment history.

Merits of Trade Credit:

1. Convenient and continuous source of funds.

2. Readily available for creditworthy customers.
3. Helps promote sales.
4. Useful for financing increased inventory to meet rising demand.
5. Does not require collateral or create a charge on assets.

Limitations of Trade Credit:

1. May lead to overtrading, increasing financial risk.

2. Limited amount of funds can be raised.
3. Generally a more expensive source of financing compared to other options.

Important: Factoring

Factoring is a financial service where a ‘factor’ provides services such as discounting of bills, debt collection,
and credit protection. It involves selling receivables at a discount, allowing businesses to receive immediate
funds. There are two types of factoring: recourse factoring, where the client bears the risk of bad debts, and
non-recourse factoring, where the factor assumes the credit risk. Factoring companies also provide
creditworthiness information and consultancy services. In India, major providers include SBI Factors, Canbank
Factors, and various banks and NBFCs.

Merits of Factoring:

1. Cheaper than bank credit.

2. Improves cash flow, enabling timely payments.
 3. Provides a steady cash inflow pattern.
4. No collateral or charge on assets is required.
5. Allows businesses to focus on core operations while the factor handles credit control.

Limitations of Factoring:

1. Expensive for businesses with numerous small invoices.

2. Interest cost on advance financing is usually high.
3. Customers may be uncomfortable dealing with a third-party factor.

Lease Financing

Lease financing is a contractual agreement where the owner of an asset (lessor) grants the right to use the asset
to another party (lessee) in exchange for periodic lease payments. This method is commonly used for acquiring
assets like computers and electronic equipment, which may quickly become obsolete due to technological
advancements. The cost of leasing should be compared with the cost of ownership before making a decision.

Merits of Lease Financing:

1. Allows asset acquisition with lower investment.

2. Simple documentation makes financing easier.
3. Lease rentals are tax-deductible.
4. Provides finance without affecting business ownership or control.
5. Does not impact the debt-raising capacity of a business.
6. The lessor bears the risk of obsolescence, allowing flexibility in asset replacement.

Limitations of Lease Financing:

1. Restrictions may be imposed on asset usage and modifications.

2. Business operations may be disrupted if the lease is not renewed.
3. Higher financial obligation if the lease is terminated prematurely.
4. Lessee never owns the asset and does not benefit from its residual value.

Public Deposits

Public deposits are funds raised by organizations directly from the public, usually offering higher interest rates
than bank deposits. Individuals can invest by filling out a prescribed form, and in return, they receive a deposit
receipt. Public deposits help businesses meet short-term and medium-term financial needs. They offer benefits
to both depositors (higher interest earnings) and companies (lower borrowing costs than bank loans). These
deposits are typically invited for up to three years and are regulated by the Reserve Bank of India (RBI).

Merits of Public Deposits:

1. Simple procedure without restrictive loan conditions.

2. Lower cost compared to bank loans.
3. No charge on company assets, allowing them to be used for other loans.
4. Does not dilute company control, as depositors have no voting rights.

Limitations of Public Deposits:

1. New companies may struggle to raise funds through public deposits.

2. Unreliable source, as public response may vary.
3. Difficult to collect large amounts when significant funding is required.

Commercial Paper (CP)

Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note.
Introduced in India in 1990, CP helps highly rated corporate borrowers diversify their short-term funding
sources. It is also used by financial institutions and primary dealers for meeting short-term funding needs. CPs
can be issued for maturities ranging from 7 days to 1 year in denominations of ₹5 lakh or multiples thereof.
Only financially sound companies with a valid credit rating can issue CPs.

Merits of Commercial Paper:

1. Unsecured and free from restrictive conditions.

2. Highly liquid as it is freely transferable.
3. Lower cost compared to commercial bank loans.
4. Provides a continuous source of funds, as maturing CPs can be replaced with new ones.
5. Companies can earn returns by investing surplus funds in CPs.

Limitations of Commercial Paper:

1. Only financially strong and highly rated firms can issue CPs, excluding new and moderately rated
companies.
2. The amount of funds raised depends on the availability of surplus liquidity in the market.
3. It is an impersonal financing method, making it difficult to extend maturity if a firm faces financial
difficulties.

Issue of Shares

The capital raised by a company through the issuance of shares is called share capital. A share represents a unit
of ownership in the company. There are two main types of shares: equity shares and preference shares.

(a) Equity Shares

Equity shares represent ownership in a company and provide long-term capital. Shareholders, known as
residual owners, receive dividends only after other claims are settled. They have voting rights and bear both
the risks and rewards of ownership.

Merits of Equity Shares:

1. Suitable for investors seeking high returns despite risks.

2. No obligation for the company to pay dividends.
3. Serves as permanent capital, repaid only upon liquidation.
4. Enhances creditworthiness and borrowing capacity.
5. Does not create a charge on company assets.
6. Ensures democratic control over management through voting rights.

Limitations of Equity Shares:

1. Investors seeking steady income may not prefer them due to fluctuating returns.
2. Higher cost compared to other sources of finance.
3. Issuing new shares dilutes voting power and earnings of existing shareholders.
4. Involves complex procedures and regulatory formalities.

(b) Preference Shares

Preference shares offer fixed dividends and have priority over equity shares in dividend payments and capital
repayment. However, they do not have voting rights and combine features of both equity shares and
debentures.

Merits of Preference Shares:

 1. Provides steady income with fixed returns.
2. Suitable for investors preferring low-risk investments.
3. Does not dilute equity shareholders' control.
4. Fixed dividends can lead to higher equity dividends in profitable years.
5. Preference shareholders have repayment priority in case of liquidation.
6. No charge is created on company assets.

Limitations of Preference Shares:

1. Less attractive for investors seeking higher returns.

2. Dilutes equity shareholders' claims over company assets.
3. Higher dividend rates than interest on debentures.
4. No guaranteed return, as dividends depend on profits.
5. No tax benefits, unlike interest on loans.

Debentures

Debentures are a significant instrument for raising long-term debt capital. They represent a company's
acknowledgment of borrowing a specific amount, which it promises to repay at a future date. Debenture holders
are creditors of the company and receive a fixed interest at regular intervals. Unlike equity shareholders, they
do not have voting rights. Public issue of debentures must be rated by a credit rating agency like CRISIL to
assess the company's financial strength and risk level.

A popular type of debenture is Zero Interest Debentures (ZID), which do not have an explicit interest rate.
Instead, investors earn returns from the difference between the debenture's face value and its purchase price.

Merits of Debentures:

1. Suitable for investors seeking fixed income with lower risk.

2. Debenture holders do not share in company profits, ensuring stable costs.
3. Ideal for companies with stable sales and earnings.
4. No dilution of control, as debenture holders do not have voting rights.
5. Lower cost compared to equity and preference shares, as interest is tax-deductible.

Limitations of Debentures:

1. Fixed interest payments create a financial burden, especially during low earnings.
2. Repayment obligation on a specified date can cause financial strain.
3. Issuing debentures reduces the borrowing capacity of the company.

Commercial Banks

Commercial banks play a crucial role in providing finance for businesses across different time periods and
purposes. They offer funds through cash credit, overdrafts, term loans, bill discounting, and letters of credit.
The interest rate charged depends on factors like the firm’s characteristics and prevailing economic rates.
Loans can be repaid in lump sum or installments.

While banks now offer longer-term loans, they primarily provide short to medium-term financing.
Businesses often need to provide security or collateral before obtaining a loan.

Merits of Commercial Banks:

1. Timely assistance—Funds are provided as needed.

2. Confidentiality—Business details shared with banks remain private.
3. Simplified process—No need for prospectus or underwriting.
4. Flexibility—Loan amount can be adjusted or repaid early.
Limitations of Commercial Banks:

1. Short-term availability—Renewal or extension of loans is uncertain.

2. Complex approval process—Requires financial investigations, collateral, and guarantees.
3. Strict conditions—Restrictions on business operations (e.g., mortgaged asset usage).

Financial Institutions

The government has established financial institutions to provide long-term and medium-term finance to
businesses. These institutions, also known as development banks, supplement traditional financial agencies like
commercial banks. They offer owned capital, loan capital, market research, technical assistance, and
managerial support, making them ideal for business expansion, reorganization, and modernization.

Merits of Financial Institutions:

1. Long-term finance—Unlike commercial banks, they provide extended funding.

2. Advisory services—Businesses receive financial, managerial, and technical guidance.
3. Enhanced credibility—Borrowing from these institutions improves market reputation.
4. Flexible repayment—Loans can be repaid in easy installments.
5. Availability in tough times—Funds are accessible even during economic downturns.

Limitations of Financial Institutions:

1. Strict approval process—Loans require extensive formalities, making them time-consuming and
costly.
2. Operational restrictions—Borrowers may face dividend payment limitations and other constraints.
3. Loss of autonomy—Institutions may appoint nominees to the Board of Directors, affecting decision-
making.

International Financing

With globalization and economic liberalization, businesses can raise funds through international sources.
Various global financing options include:

1. Commercial Banks

 Provide foreign currency loans for international business.

 Example: Standard Chartered is a major lender to Indian industries.

2. International Agencies and Development Banks

 Offer long-term and medium-term loans to support global trade and economic development.
 Examples: International Finance Corporation (IFC), EXIM Bank, Asian Development Bank
(ADB).

3. International Capital Markets

Businesses and multinational companies use financial instruments such as:

(a) Global Depository Receipts (GDRs)

 Issued abroad by Indian companies to raise funds in foreign currency.

 Traded on foreign stock exchanges.
 Holders receive dividends and capital appreciation but no voting rights.
 Example: Used by Infosys, Reliance, Wipro, ICICI.
(b) American Depository Receipts (ADRs)

 Issued in the USA and traded like regular stocks in American markets.
 Similar to GDRs but issued only to U.S. citizens.

(c) Indian Depository Receipts (IDRs)

 Foreign companies raise funds from the Indian market.

 Denominated in Indian Rupees.
 Example: Standard Chartered PLC was the first company to issue IDRs in India (June 2010).

(d) Foreign Currency Convertible Bonds (FCCBs)

 Equity-linked debt instruments issued in a foreign currency.

 Can be converted into equity shares at a predetermined price after a specific period.
 Traded in foreign stock exchanges.
 Carry lower interest rates than similar non-convertible bonds.

These international financing options provide businesses with greater access to capital, lower costs, and
global market exposure.

CH – 7 FORMATION OF THE COMPANY

Memorandum of Association

The Memorandum of Association (MOA) is the most crucial document for a company, defining its objectives
and scope of operations. As per Section 2(56) of the Companies Act, 2013, the MOA outlines the company's
structure and activities. It contains the following clauses:

1. Name Clause – Specifies the approved name of the company.

2. Registered Office Clause – Mentions the state where the company’s registered office will be located,
with the exact address to be notified within 30 days of incorporation.
3. Objects Clause – Defines the company's objectives and limits its activities to those stated in this
clause.
4. Liability Clause – Limits members’ liability to the unpaid amount on their shares.
5. Capital Clause – Specifies the authorised share capital of the company and its division into shares.

The MOA must be signed by at least seven members for a public company and two members for a private
company. The applicable format is provided in Tables A to E of Schedule I based on the company type.

Articles of Association

The Articles of Association (AOA) contain the rules for the internal management of a company. These rules
must align with the Memorandum of Association (MOA) and cannot contradict or exceed its provisions.

As per Section 2(5) of the Companies Act, 2013, the AOA can be framed initially or modified over time.
Companies can either adopt the standard AOA provided in Tables F to J of Schedule I or create their own.

The respective forms for AOA are:

1. Table F – AOA of a company limited by shares

2. Table G – AOA of a company limited by guarantee with share capital
3. Table H – AOA of a company limited by guarantee without share capital
4. Table I – AOA of an unlimited company with share capital
5. Table J – AOA of an unlimited company without share capital
Companies have the flexibility to draft their own AOA, overriding the standard forms if necessary.

Capital Subscription

A public company can raise funds by issuing securities (shares, debentures, etc.) to the public. It must follow a
set process, including regulatory approvals and investor protection measures.

The key steps involved are:

1. SEBI Approval – The company must obtain approval from SEBI (Securities and Exchange Board of
India) to ensure transparency and investor protection.
2. Filing of Prospectus – A prospectus or a ‘Statement in Lieu of Prospectus’ is filed with the Registrar
of Companies to invite public investment. It must disclose all relevant details and avoid misstatements.
3. Appointment of Bankers, Brokers, and Underwriters – Bankers handle application money, brokers
sell shares, and underwriters (if appointed) commit to buying unsold shares.
4. Minimum Subscription – The company must receive at least 90% of the issue size; otherwise, the
money is refunded to applicants.
5. Application to Stock Exchange – The company must apply to a stock exchange for listing. If
permission is not granted within ten weeks, all collected money is refunded.
6. Allotment of Shares – Shares are allotted, and excess application money (if any) is refunded. A
Return of Allotment must be filed with the Registrar within 30 days.

If a public company does not invite public investment, it can raise funds privately, similar to a private
company, by filing a ‘Statement in Lieu of Prospectus’ with the Registrar.