Chapter - 5Chapter - 5Chapter - 5Chapter - 5

FINANCING FINANCING

FINANCING ?

Financing is the process of planning, acquiring,utilising,and controlling the funds used in any kind of Business. Finance is the life blood of every business.

Capital for Different types of Business

• Capital for sole proprietorship:A sole proprietor operates at a small scale and therefore ,requires a limited amount of capital. The proprietor brings his own capital. In a sole proprietor ship, owned capital consist of the owner’s own contribution and retained profits credited to his capital account at the end of each financial year.

• In addition the proprietor can raise funds from the friends, relatives and even from the bank.shorterm loan for working capital can be raised from commercial banks.

• Long term loans for purchase of fixed assets are available from SFC.But this facility is only for the short period.

capital for partnership firm• Capital requirements as well as the

capital base of a partnership is bigger than that of a sole trader business.

• The owned capital is contributed by the partners as in agreed ratio.

• A partnership firm can also raise funds from commercial banks and financial institutions.

Capital for joint stock company

• A joint stock company generally requires large amount of capital. A public company can raise huge capital through issue of shares .

• In addition to share capital it can utilise retained profits in the form of reserves.

• It can raise borrowed capital through debentures and loans.

CAPITAL PLANNING• A suitable capital plan is essential for the

success of every business enterprise.• It should provide for;• a) Accurate estimate of the total capital

requirements• B) Selection of right methods or sources of

finance for raising the estimated capital.

The capital requirements of a Corporate Enterprise consist of the Following;

• 1) cost of promotion (preliminary expenses) Several expenses are incurred on the formation

and incorporation of a company. These expenses incurred upon the incorporation of a company are known as promotional expenses. Expenses on preliminary investigation, legal and technical advise, drafting and printing of documents, Registration fee, office expenses, remuneration paid to Promoters,etc are the examples of such expenses

Cost of financing• A company has to incur expenses on the

procurements of funds from the public. These expenses are the cost of financing. These include advertising, printing and publishing of Prospectus and application forms,underwriting,commision,brokereage and other expenses on the marketing of Securities.

• COST OF FIXED ASSETS; Fixed assets are the permanent Assets of

the firm .These include land and buildings, plant machinary,furniture,and fixtures etc.Large amount of money we need to invest for this.

COST OF INTANGIBLE ASSETS

• Intangible assets like goodwill, patents etc.should also be taken into consideration while determining the capital requirements of the company. A new firm may have to acquire goodwill and patent Rights from existing firms.

• COST OF CURRENT ASSETS; Current assets include cash Debtors ,bill

receivable stock of goods etc.sufficient amount of current assets is necessary for the smooth functioning of a Business.

COST OF DEVELOPING BUSINESS

• Often a large company takes some period before its start generating profits.

• The operating losses incurred to reach the break –even stage (no profit-no loss) are the cost of developing business.

• such cost should be taken into consideration while estimating the capital requirements of a company.

FACTORS AFFECTING CAPITAL FPLANNING

• NATURE OF BUSINESS• SIZE OF BUSINESS• CASH INFLOWS• COST OF RAISING CAPITAL• PERIOD OF FINANCE• FLEXIBILITY OF CAPITAL STRUCTURE• TRADING ON EQUITY (use of borrowed fund for

increasing rate of return on equity shares.)

• CONTROL OF THE COMPANY• NEEDS OF INVESTORS• CAPITAL MARKET CONDITION• LEGAL REQUIREMENTS

FIXED CAPITAL• FIXED CAPITAL REFERS TO THE FUNDS

REQUIRED FOR ACQUISITION OF FIXED ASSETS.

• FIXED ASSETS ARE MEANT FOR GENERATING INCOME.

• THESE ASSETS ARE USED PERMANENTLY FOR BUSINESS OPERATION.

• LAND&BUILDING,PLANT AND MACHINERYFURNITURE AND FIXTURES,MOTOR VEHICLES ETC.

FACTORS DETERMINING FIXED CAPITAL

• NATURE OF BUSINESS• SIZE OF BUSINESSASSETS.• NATURE OF PRODUCTS• METHOD OF PRODUCTION(INTENSIVE)• DIVERSITY OF PRODUCTS LINE• MODE OF ACQUIRING FIXED

ASSETS(LEASE OR HIRE PURCHASE)• INTANGIBLE. (GOODWILL PATENT)

WORKING CAPITAL

• It is also known as Circulating Capital

• It means the capital invested in working assets or current assets such as cash, stock of goods, short term investment etc..

• It represent the liquid fund for the day to day operation.

WORKING CAPITAL

• The term working capital is used in two senses- Gross working capital and net working capital.

• Gross Working capital: The gross working capital means the total amount of funds invested in current assets.

• Current assets are those assets which are converted into cash in the ordinary course of Business.

• Gross working capital=Book value of current assets.

WORKING CAPITAL

• Net working capital; It means the excess of current Assets

over current liabilities. Current assets include cash in hand,

cash at bank, Sundry debtors etc.. Current liabilities are: sundry creditors,

bills payable etc… NET WORKING CAPITAL=CURRENT

ASSETS-CURRENT LIABILITIES.

TYPES OF WORKING CAPITALWorking capital is broadly divided in to Two; a) Permanent working capitalb) Temporary working capitalPermanent working capital is again divided in to two;a) initial working capitalb) Regular working CapitalTemporary working capital is again divided in to two;a) Seasonal working capitalb) special working capital

Permanent working capital

It refers to the minimum amount of working capital required permanently to operate the minimum level of business activity. It is permanently locked up in current assets.

• It is therefore raised through long-term sources of finance.• Initial working capital; This capital is that part of permanent

working capital which is required at the time of commencement of business.

• Regular working capital ; It means that part of permanent working capital which is required for the continuous business operations.

• It represents the excess of current assets over current liabilities.

• It consists of enough cash to meet short term obligations, to build up inventory and enough stock of finished goods to ensure quick delivery to customers.

Temporary or variable working capital

• It is the working capital that is required in addition to the permanent working capital.

• It is required to meet seasonal and special needs of business.

• It is fluctuating in nature and is, therefore known as variable working capital.

• The amount of temporary working capital depends upon the extent of extra demand in season and exigencies of urgent circumstances.

• It is generally raised from short-term source of finance.

Temporary or variable working capital.

Seasonal working capital; It means extra working capital during some seasons. woolen

(garments, umbrella) Special working capital: It refers to extra funds required to meet future contingencies that

may arise in business. It is advisable to set up a reserve working capital to act as a

cushion in times of emergencies. A Business firm must set aside additional funds to cope with

unforeseen contingencies such as; a) special operations to meet sudden spurt in demand. b) Depression c) strikes, lockout and natural calamities etc…

Importance of working capital

• Timely payment of dues• High credit worthiness• Cash discount• Availing business opportunities• Good relations with employees• Timely payment of dividends.

Factors determining working capital• Nature of Business (Manufacturing industry need

considerable working capital than public )

• Size of business• Manufacturing cycle (It means time involved in the

production of goods. If it take more time we need higher amt of W.C)

• Rapidity of turnover (If turn over is high we need small amount of capital)

• Terms of purchase and sale (credit sale we need large amt of capital)

• Credit policy

• Operating efficiency( Better utilisation of resource)

Factors determining working capital

• Goodwill of business• Growth and expansion plans.• Seasonal variation• Cyclical fluctuation (Boom period

need large working capital,

Types of finance• It is broadly divided in to three;• Ie: on the basis of need• on the basis of ownership• on the basis of duration.• On the basis of need it is classified as Fixed Capital and

working capital.• On the basis of ownership it is classified as Owned and

Borrowed capital • On the basis of Duration It is classified as Long term

and short term capital.

Source of finance for Joint stock company• A Business enterprise need adequate funds at

reasonable terms to start and operate its activities.• Some funds for long term and some funds for shorter

purposes.• Long term funds can be raised through issuing

shares,Debentures,ploughing back of profit and loans from financial institutions.

• Short term funds may be collected through commercial bank,public deposits, trade credit and another sources.

Source of finance for Joint stock company• In every Business enterprise there are two types of

capital• a) Equity or owned capital• b) Debt or borrowed capital• Owned capital consist of equity share capital,

preference share capital and ploughing back of profits.• This amount belongs to the owners.• It remains in business until the winding up of the firm

and its there fore the permanent capital.

Debt or borrowed capital• Debentures, public deposits and loans are borrowed

capital.• Interest at the specified rate has to be paid periodically

on these and principal amount must be paid on expiry of the date.

• Borrowed funds belong to the creditors are and generally obtained by creating a charge on the assets of the company.

Sources of finance • Sources of finance are divided into two;• a) long term finance b) short term finance• Long term finance consist of • 1 equity shares• 2 preference shares• 3 Debentures• 4 Loans from specialised financial institution• 5 ploughing back of profits.

Sources of finance• Short term finance :• 1 public deposits• 2 Bank credit• 3 Advances from customers• 4 Trade credit

Shares • Issue of shares is the most important method of raising long

term funds.• Shares are the ownership securities and share capital

represents the ownership capital.• Funds raised through shares provide a financial base to the

company.• The AOA specified certain rights on its share holders• A public company Ltd by shares can issue 2 types of shares• A) preference shares• B) equity share• A private company can also issue deferred shares• Equity shares can be of 2 types. a) with voting rights b) with

differential rights as to get dividend,c)voting or otherwise in accordance with such rules and subject to such conditions as may be prescribed.

Preference shares • Preference shares are the shares which carry certain privileges

or preferential rights- both regarding the dividend and the return of capital.

• First dividend at a fixed rate must be paid on preference shares before any dividend is paid on equity shares

• Secondly,. In the event of winding up of the company, preference share holders must be paid back their capital before equity share holders.

• Generally preferential share holders do not carry any voting rights except when dividend is outstanding for more than 2 years.

Types of preference shares

• Cumulative and non cumulative preference shares:

In the case of cumulative preference shares dividends not paid in a particular year are carried forward to the next year.

Such unpaid dividends go on accumulating and become payable out of the profits in subsequent years.

Such areas of dividend must be paid before dividend is paid on any other class of shares.

Types of preference shares

• Non cumulative preference shares; non-cumulative preference shares dividends

do not accumulate. In case the company does not have sufficient

profits in any year, the right to dividend in respect of that year is lost for ever.

divident claim is not carried to subsequent years.

Types of preference shares

• Participating and non participating preference shares:

Participating preference shares give the holder the right to share in the profits left after the payment of dividend to preference and equity shareholders.

Holders of participating preference shares are entitled to participate in the surplus profits of the company in additional to the normal fixed rate of dividend

The holders of non participatory shareholders do not enjoy the right to share in the surplus profits. They get only the fixed dividend.

Types of preference shares

Convertible and nonconvertible preference shares:

Holders of convertible preference shares can get such shares converted into equity shares after a fixed period.

On the other hand, preference shares which cannot be converted into equity shares are known as non convertible preference shares.

Types of preference shares

• Redeemable and irredeemable preference shares: The holders of redeemable preference shares

can be refunded their capital after the expiry of a specified period or at the discretion of the company as stated in the Articles of Association

Non redeemable preference shares cannot be redeemed before the winding up of the company.

Advantages of preference shares• From companies point of view;

1) Appeal to cautious investors. Preference shares greatly appeal to those

inventors who look for reasonable safety of their capital along with a fixed but higher return than that obtainable on debentures.

Advantages of preference shares

• 2) No burden on profits; Preference share do not put a fixed

burden on finances as dividend are payable only out of profit. The cost of finance is also less.

3) No interference in management; Generally, preference shares do not carry

voting rights. There fore, promoters can retain exclusive control over the company by issuing preference shares to outsiders. There is no dilution of control

Advantages of preference shares• 4) No charge on assets; Issue of preference shares does not involve any

mortgage or change on the assets of the company. The company can keep its fixed assets free to be used for raising loans in future.

5) Trading on equity; Rate of dividend on preference share is fixed. when

the companies earnings raise, the company can pay higher rates of dividend to equity share holders. Preference shares in econonomical source of finance because the rate of divident is usually low.

Advantages of preference shares

• 6) flexibility; In case of redeemable preference shares

the amount can be repaid as and when the company does not need it. The participating or convertible preference shares can be issued to attract investors who want to share in the growing prosperity of the company. preference share capital is considered a part of Net worth. it increase the credit worthiness of the company.

Advantages on investors point of view• Investors get a more stable and regular dividend before

payment of equity divident.Rate of dividend is fixed.• The risk involved is comparatively less because

preference share capital is payable before equity share capital on the winding up of the company.

• Preference shareholders can expect to get back their investment after a certain time period but preference share cannot be issued for a period of more than 20 years.

• In case of cumulative preference share the areas of dividend also accumulate and payable in future.

Disadvantages of preference share on view point of company.

• Costly source; The cost of raising finance through

preference shares is greater than that of debentures. Preference dividend is not deductable for tax purposes.

Permanent burden; Dividend is distributed at fixed rate before

any dividend paid on equity. Legal formalities; Redemption on preference share include

several legal formalities.

Disadvantages of preference share on view point of company.

• Low appeal; Preference shares have low appeal to

investors. Cautious and conservative investors prefer Debentures. Risk taking investors prefer equity shares. There fore a companies can raise limited funds through preference shares.

From the view point of share holders• Lack of voting rights; preference share do not carry voting rights in the

normal course. when the companies earnings rise rapidly, holders of such shares do not get a share in the prosperity of the company except in case of participating preference shares.

Fear of being shown the door; Holders of redeemable preference shares have to face

yet another unpleasant prospect. The company raise capital from them when it is badly in need of funds. But once its purpose is served ,its bids goodbye to them by paying back their money.

From the view point of share holders• No capital appreciation; preference shares do not get the benefit of appreciation

in their investment. they doesn't share in the prosperity of the company during boom period.

No guarantee of dividend; payment on dividend on preference shares is not

guaranteed. Rate of dividend is generally modest. price fluctuations of preference shares is greater than that of debentures. These shares are less easily saleable on stock exchanges than equity shares.

Advantages and disadvantages of preference shares

Sl no Advantages Disadvantages

1 Appeal to caution investors

Limited appeal due to uncertain return

2 No charge on assets Fixed liability

3 No burden on profits Lack of voting rights

4 No interference in management

Fearing of showing the door

5 Trading on equity

6 flexibility

Equity shares • Shares which carry no preference

rights or priority in the payment of dividend and in the repayment of capital are called equity shares or ordinary shares

Advantages of equity shares ?

• From companies point of view;• No burden on earnings (subject to the availability of profit)• Permanent capital (refunded only at the time of winding

up)• No charge on assets. (the company free to use its

property)• Source of strength (ability to borrow)• Small nominal value face value of share is low. So it got

wide appeal .savings can be mobalise easily.

Advantages of equity share• From shareholders point of view;

• Equity shareholders enjoy voting rights and controlling powers over the company

• The liability of equity share holders is limited to the face value of shares subscribed by them.

From shareholders point of view;

• In case of a successful business the rate of dividend can be very high eg:Hero Honda paid 900% dividend during 2008

• Equity shareholders have the right to subscribe to new shares issued by the company. such shares called right shares.

• The value of investment in equity shares may increase manifold during boom and prosperity of the company holders of these shares earn capital gains.

• Shareholders are not required to pay income tax on dividends received from the company.

Disadvantages of equity shares

• On companies point of view;• Manipulation of control; misuse the voting rights• Danger of over capitalisation (can't refundable before

winding up of the company)• No trading on equity( when entire share capital is

collected through equity ,benefit of trading on equity is not possible)

• Costly (cost of issuing equity share is higher than other shares)

• Inflexible (company cannot issue shares in excess of its authorised capital as stated in the memorandum of association)

Disadvantages of equity shares• On shareholders point of view;• Perpetuation of control by a few (any new

issue of equity shares has to be first offered to the existing shareholders.

• High risk; They sink or swim with the company.uncertainity

Unhealthy speculation