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MODULE 2
SOURCES OF FINANCING
The business firm should have sufficient sources of financing to meet its
investment needs. All firms requires two types of finance namely:
1) Long term financing/ financing for capital assets
2) Short term financing / working capital financing
The firm may have basically two sources of financing namely
internal sources and external sources. Former includes depreciation fund
and retained earning where as later includes various debt and equity
sources.
Internal sources:
i) Depreciation fund
ii) Capitalization of retained earnings
External sources:
1) Long term:
a) Equity / preference shares
b) Term loans
c) Debentures/ bonds
d) Leasing/ hire purchase
e) Venture capital etc.
2) Short term:
a) Trade creditors
b) Cash credit / overdraft
c) Short-term loans/ bill discounting
d) Export financing etc.
1) INTERNAL SOURCES OF FINANCING:
Depreciation fund maintained and retained earnings constitute
important source of internal source of financing. By capitalization the
retained earnings the firm can use the fund for desired purpose.
Advantages:
1) It is readily available internally
2) It is additional equity without any cost
3) No dilution of control
Limitations:
i) Amount funds that can be raised is minimum
ii) This source is available only with an existing firm
iii) Opportunity cost of this source is very high.
2) EQUITY SHARES:
Equity capital is also a ownership capital. Equity shareholders
enjoys the profit of the firm on one hand and bears the risk on the other
hand.
i) Authorized capital: It is the maximum capital which an
organization can issue.
ii) Issued capital: It is that part of authorized capital which is actually
issued by the company.
iii) Subscribed capital: It is that capital which is subscribed by the
public when it was issued.
iv) Called up and paid up capital: It is the equity capital which is
actually paid by the investor.
Book value: It is the value of the equity shares, as shown in the balance
sheet.
= Paid up equity capital + reserves and surplus / No. of equity shares.
Face value: It is the normal price of the shares to be issued by the
company.
Issue price: It is the price at which the company issues the shares, usually
its more than face value.
Market price: When shares are traded in secondary market the prevailing
price is a market price.
Features of equity shares:
i) Residual claim on income:- After paying interest, tax, preference
dividend, the remaining profit is distributed to equity share holder.
ii) Residual claim on asset: While repaying capital also equity
shareholders stands last.
iii) Right to control : the firm
iv) Voting rights are available to share holders
v) Pre-emptive rights: This rights of equity shareholders makes the
company to offer additional equity shares to existing equity holders
before it is offered to general public.
vi) Limit liability arises in case of equity capital.
Merits:
a) It is a permanal source – no maturity period
b) No compulsion to pay dividend
c) It provides cushion to lenders
d) Dividend on equity capital is tax exempted in the hands of
investors.
Limitations:
i) Dilutes the control
ii) Floatation (issue cost) cost is very high
iii) Dividend on equity is not allowed as deduction for tax purpose,
more over there will be a additional tax on dividend declared.
Issue of equity shares:
Firm can raise finance by issuing equity shares in different forms like:
a) By going for IPO
b) By going for subsequent issue
c) By right issue
d) By private placement
e) By preferential allotment
a) Initial public offer of equity shares (IPO):-
If the firm is issuing the shares for the first time, it is referred to as
initial public offer. Initial public offer will be followed by listing of the
equity shares in the stock exchange.
Benefits of going public:
Access to capital
Respectability
Investors recognition
Liquidity to promoters
Signals from markets
Cost of going public (limitations):-
Dilution of control
Loss of flexibility
Disclosure
Accountability
Public pressure
Costs associated with issue
Steps involved in IPO
Approval of board of directors
Appointment of lead managers (merchant banker)
Appointment of other intermediaries like co-managers,
underwriters, registrar, bankers, brokers etc.
Filing of prospectus with SEBI
Filing of prospectus with Registrar of companies.
Printing and dispatch of prospectus
Statutory announcement of the issue
Promotion of the issue
Collection of application by lead manager
Processing of application by lead manager
Allotment of shares
Listing of the shares in stock exchange.
b) Subsequent issue/ public issue by listed companies:
A company whose shares are already listed in stock exchanges may
think of generating some more finance by issuing equity shares. this is
referred to as subsequent issue.
The company need to fulfill certain conditions before going for
subsequent issue of equity shares like:
a) Company should be listed in stock exchange for atleast 3
years.
b) Company need to have a track record of payment of dividend
for atleast 3 years immediately proceeding the year of issue.
Procedure for issue of equity shares of a limited company is similar
to that of an IPO. The company is having a freehand in fixing the prices
of subsequent issue. The general practice in India is that 6 months average
closing price is taken as issue price.
c) Right issue:
Right issue involves selling equity/securities in the primary market
to existing shareholders. This can be done after meeting some
requirements specified by SEBI.
When company issues additional capital, it has to be first offered to
existing shareholders. The shareholders however may forfeit this right
partially or fully to enable the company to issue additional capital to
public.
Characteristics of right issue:-
1) Number of rights that a shareholders gets is equal to the number of
shares held by him.
2) The number of rights required to subscribe an additional shares is
determined by issued company.
3) Price per share is determined by the company.
4) Existing shareholders can exercise right and can apply for the
share.
5) Shareholders who renounce their rights are not entitled for
additional shares.
6) Rights can be sold
7) Rights can be exercised only during a fixed period (usually 1
month)
Desired funds
Number of new shares = ---------------------------------
Subscription / offer price
Existing shares
Number of rights required to get an additional shares = ----------------------
New shares
Price of the share after right issue =
Existing shares x current M.P. + new shares x subscription price
= --------------------------------------------------------------------------------------
Total shares (existing + new shares)
Merits of right issue:
1) Less expensive as compared to direct public issue
2) Management of applications and allotment is less cumbersome.
Limitations:
i) Can be used by only existing company
ii) Cannot be used for large issues
iii) Wider ownership bare cannot be achieved.
d) Private placements
It involves allotment of shares (or other securities) by a company to
few selected sophisticated investors like mutual funds, insurance
companies, banks etc.
Private placement of equity:- Usually unlisted companies who are not
ready for IPOs can go for this. Price can be freely determined by
company as it is not regulated by SEBI.
Private placement of debt:- Companies can directly place their
debentures, bonds etc.
In Indian context private placement of debt of listed companies and
equity of unlisted companies are popular.
Advantages of private performance:
1) Helpful in rising small size of funds
2) Less expensive as compared to other methods
3) Takes less time as compared to other type of issues.
e) Preferential allotment:
It is an issue of equity by a listed company to selected investors at a
price which may or may not be related to prevailing market price. It is not
a public issue of shares. This kind of preferential allotment is made
mainly to promoter or their friends and relative.
The company should pass special resolution to do preferential
allotment. In case if the government is having a state in the company., the
central government permission is necessary.
Pricing:- price of preferential allotment must not be lower than 6 months
average closing price.
Pricing regulations of preferential allotment to FII’s are more
stringent.
Lock in period:- The shares allotted under preferential allotment process
will attract a lock in period. If it is allotted a promoter, the lock in period
will be 3 years and to others, it is 1 year.
3) PREFERENCE SHARE CAPITAL:
It is an unique type of long tem financing which combines some of
the characteristics of equity shares as well as debentures.
It is similar to equity capital because:-
a) Dividend to equity capital because:
b) Not obligatory to pay dividend
c) Irredeemable type does not have any maturity.
It is similar to debenture because:
a) It carries fixed dividend
b) It is ranked higher than equity on the basis of claim
c) It does not have any voting rights normally
d) It does not have any share in residual earnings.
Features of preference shares:
1) Prior claim on income/ asset:- Prior claim arises as compared to
equity shares.
2) Cumulative dividend:- Dividends get accumulated and must be
paid before paying dividend to equity shareholders.
3) Redeemability:- At the end of maturity period the preference
shares need to be redeemed.
4) Fixed divided:- Preference shares carries fixed of dividend.
5) Convertibility:- Preference shares can be converted into equity
shares at the end of maturity period.
6) Voting rights:- Generally preference shareholders does not possess
voting rights, but if dividend on preference shares is not paid for 2
or more consecutive years than preference shareholders gets voting
rights.
7) Participation feature:- Preference shares holders may enjoy
participation in additional profits of the organization.
8) Sinking fund:- Sinking fund may be created by issuing company
to retire preference shares.
9) Call feature:- If preference shares carried call option, company
can buy back the preference shares before its maturity.
Types of preference shares:
i) Redeemable and irredeemable preference shares:-
Redeemable is one which can be redeemed/ re-purchased by the
company after the maturity period of shares on the other hand the shares
which cannot be retired by the company is termed as irredeemable
preference shares.
ii) Convertible and non convertible preference shares
If the preference shares can be converted into equity shares at the
end of maturity period it is termed as convertible preference shares. If the
company does not convert preference shares into equity shares it is called
as non-convertible preference shares.
iii) Participative and non-participative preference shares
If preference shareholders enjoys additional dividend in case of
extra profit or if they enjoys additional capital in case of liquidation of the
company. It is termed as participative preference shares. If such
participation is not available it is termed as non-participative preference
shares.
iv) Cumulative and non cumulative preference shares:
Unpaid dividend of one year it gets accumulated to next period it is
termed as cumulative preference shares. If dividend does not get
accumulated it is termed as non-cumulative preference shares.
Advantages of preference shares:
a) Risk less source of finance:
Dividend payment is not compulsory in case of preference shares
and claims of promoters does not get dilated, it is considered as risk less
source of finance.
b) Stable dividend:
The company need not have to pay any extra dividends even when
there is a extra profit.
c) Limited voting rights is available to preference shares
d) Redemption of preference shares can be delayed without any
significant penalty
Limitations of preference shares:
i) No tax advantage:
Payment of dividend on preference shares is not allowed as
deduction for tax purpose.
ii) Cumulative dividend:
The company has to pay all the accumulated dividend on
preference shares before dividend is payable to equity shareholders.
4) DEBENTURES:
Debentures / bond is a debt instrument indicating that a company
has borrowed certain sum of money and promises to repay if future under
clearly defined terms.
Debenture holders are the long term creditors of the organization
and are eligible to get stipulated amount of interest and re-payment on the
maturity.
Features:
a) Interest:- Debentures carries a fixed rate of interest, which is a
contractual payment by the company. Interest is allowed as
deduction for tax purpose.
b) Maturity:- debentures have fixed maturity usually 7 – 10 years.
They are redeemable after the maturity period.
c) Redemption:- After the maturity debentures are redeemed. They
may be redeemed at par or at premium.
d) Sinking fund:- A sinking fund si created by the company for the
purpose of redemption of the bond. Every year a fixed sum is
transferred to the fund and that money will be used to redeem the
debentures.
e) Buy back/ call provision:- Company may exercise call option,
there by can redeem the debentures before the maturity wherever
buy back is done the company has to redeem at a premium.
f) Trust:- When the debentures is issued by the company a trust is
created. It includes trustees drawn from company’s directors,
investors, bankers etc. it is the duty of the trust to protect the
interest of the investors.
g) Security: Debentures are either secured or unsecured. If it is
secured the debenture holders can exercise lien on company’s
assets.
h) Yield:- Debentures are listed in the stock exchange there will be a
market value of debentures. Yield on the debenture is related with
its market value.
i) Claims on asset and income:- Before payment of dividend to
shareholders interest on debentures are paid same way. Before
payment of capital to shareholders, capital be paid to debenture
holders, therefore debentures holders are having preferential claim
over shareholders.
j) Compulsory credit rating:- The company issuing debentures need
to take compulsory credit rating from approved agencies.
Types of debentures:
i) Non convertible debentures: There are the debentures, which will
not converted in to equity shares by the company.
ii) Fully convertible debentures:- These are the debentures which
will be fully converted into equity shares as per the terms of issue.
The conversion will be made at the end of stipulated period.
iii) Partly convertible debentures: Here only a part of debenture will
be converted into equity shares at the end of the period and
remaining part will be redeemed by the company.
iv) Innovative debt instruments
1) Zero interest debentures/bonds (ZIB):-
Zero interest bonds, do not carry any explicit interest. They
are sold at discount, the difference between face value and
acquisition price is the return/ gain on the bond.
For eg:- Rs. 100 face value bond may be issued at Rs. 50 for period
of 6 years. The investor pays Rs. 50 on the bond at the time of issue
and gets RS. 100 on maturity.
Face value/ market value
Acquisition price = ----------------------------------
(1 + K)n
2) Deep discount bonds:
It is similar to ZIB. In case of deep discount bond, it carries a
marginal rate of interest and issued at discount and redeemed as
par.
Example :- Rs. 100 face value bond issued at Rs. 70, 6 years and
redeemed at Rs. 100 over 6 years period it carries a interest of 3
years.
Organization like IDBI, SIDBI have issued this type of debentures.
3) Secured premium notes:
It is a secured debenture which is redeemable at premium in
different installments. It carries no interest in lock-in period.
TISCO has issued in 1992.
Example:- Rs. 100 face value instrument is issued at par, for 3
years there will be no interest from 4th year onwards till the 8th year
it will be redeemed at RS. 35 per annual.
4) Floating rate bonds:
Interest rate on these bonds are not fixed. Interest is linked to
market rate of interest. Interest is payable on the benchmark rates
like bank rate, maximum interest on term deposits etc.
Advantages of debentures:
a) Less costly : as compared to equity shares
b) Tax deduction :- Interest payable on debentures is allowed as
deduction for tax purpose.
c) No ownership dilution:- As the debenture holders does not carry
any interest payment.
d) Fixed interest:- Interest rate does not increases with increase in
profits of organizatin.
e) Reduced real obligation:- Although interest payable is fixed, with
the change in inflation rate, the real obligation the part of the
company reduces.
Limitations of debentures:
i) Obligatory payment:- If the company fails to pay the interest on
debentures the investors can ask for the declaring company as
bankrupt. Interest payment on debenture is obligatory.
ii) Financial risk associated with debenture is higher than shares.
iii) Cash out flow on maturity is very high.
iv) The investors may put various restrictions/ covenants while
investing in the debentures.
COVENANTS:
There are different ways in which the equity holders can mismanage the
funds belonging to debenture holders. This leads to default risk to
debentures. This possibility arises in the following circumstances.
Excess dividend payment to equity shareholders.
By issuing more debentures diluting the claim.
Asset substitution where by funds may be used for higher
risk projects.
Under investment of funds.
Therefore debt holders should try to protect their interest. Supplier
of debt may include several covenants (conditions) in the debt agreements
to protect their interest.
Covenants are meant to protect the interest of debentures against
dilution of claim, asset depletion, asset substitution and under-investment.
Broad categories of covenants:
1) Positive covenants:
These covenants indicates what the firm should do in order to
protect the interest of the investors.
Example:
a) Submission of periodical returns
b) Maintaining minimum working capital
c) Maintaining sinking fund
d) Maintaining minimum networth etc.
2) Negative covenants:
There covenants restricts certain actions by borrowing firm without prior
permission of lender.
Not to issue additional debt and dilute the claim
Not to diversity the activity
Not to dispose or lease out the asset
Not to declare the dividend to shareholders beyond a given
percentage.
LEASING:
Leasing is one of the important indirect sources of financing. It is a
process by which firm can obtain the use of certain fixed assets, for which
it must makes a series of contractual periodic tax deductable payments.
Parties to lease
a) Lessor:- Lessor is the owner of the asset. Leasing is a core
business to the lessor.
b) Lessee:- user of the capital asset is a lessee. For lessee
leasing is a indirect source of financing.
Features of leasing
a) Asset owned by lessor is used by lessee for, which he makes
periodical lease rentals.
b) Ownership of the lease remains with the lessor throughout the
period of lease.
c) The scrap value of the asset is enjoyed by lessor, as he is the
owner of the asset.
d) Period of the lease agreement may be throughout the economic
life of the asset, or for a period shorter than that
e) Lease rental payment made by lessee is allowed as a deduction
for tax purpose.
Types of lease
1) Operating lease:-
Characteristics:-
i) Period of lease is less than economic life of the asset
ii) Lessee has got the right to terminate the lease.
iii) Usually lessor needs to take care of insurance and
maintenance of the asset.
iv) Operating lease is used usually in case of general purpose
asset.
2) Financial lease:-
a) This type of lease is used in case of special types of assets
needed specifically by a lessee.
b) Period of lease is throughout the life of the asset
c) It is a non cancelable agreement
d) Lessee is responsible for insurance and maintenance of the
asset.
3) Sale and lease back: In this type of lease the lessee sells the asset
belongs to him to lessor and same asset is taken back on lease basis
again.
4) Single investor lease:- In this case the asset is fully financed by the
lessor alone.
5) Leveraged lease:- Here the asset is not solely financed by lessor.
There will be a financier who invest the major portion of the
investment in asset.
Domestic lease and international lease:-
If both the parties to lease agreement is situated in the country it is
termed as domestic lease and if any one party to the case is residing
abroad it is a international lease.
Advantage of lease
To lessee:
It provides financing or capital asset
It is an additional source of finance
It is less costly method, especially where the asset is required
for a shorter period.
No dilusion of control and ownership is preserved.
There will be a flexibility in structuring the lease rent.
It is simple source of finance
Obsolescence risk is alerted.
To lessor:
Full security of asset is ensured in lease agreement
Lessor can charge depreciation on asset and thereby can
enjoy tax benefit.
Leasing business is highly profitable.
Limitation of lease:
There will be restriction on the usage of the asset.
Lessee loses the residual (scrap) value of the asset.
Financial evaluation of lease:
Leasing v/s buying the asset out of own funds
Buying alternative:
a) Pr of cash outflow on account of buying the asset out of
own funds
xxx
b) NPR of cash outflow on account of leasing the asset xxx
Wherever cash flow is less that alternative is selected:
‘B’ year (i) lease rent
(ii)tax savings on
a/c of lease rent
(iii) = (i – ii) Effective lease rent
Pr of effective lease rent
1 - - - -
2 - - - -
3 - - - -
- - - - -
- - - - -
N.Pr of effective lease rent xxx – ‘B’
HIRE PURCHASE FINANCING
Similar to leasing, hire purchasing is also one of the method of
capital asset financing. Here gods are let on hire, the purchase price is to
be paid in installments and hirer is allowed an option to purchase the
goods by paying all the installments.
Parties:
Hiree :- Owner of the asset who gets hire charges.
Hirer :- User of the asset
Features
Hiree purchases the assets and gives it on hire to the hirer.
Possession is delivered to the hirer at the time of entering
into the contract.
The hirer pays the regular installments over a specified
period of time. (The installments covers principle amount
and interest).
Usually interest is charged on flat basis on initial investment.
Default in payment of installments entitus seller to take away
the goods.
Hirer becomes the owner of the asset on payment of last
installments.
The hire purchaser is tree to return the goods without
required to pay any further installments.
Leasing v/s hire purchasing
Leasing Hire purchasing
1) Lessee cannot claim depreciation
for tax purpose
Hirer is although the owner of the
asset can claim depreciation
2) Lessee cannot enjoy the
ownership therefore he cannot
enjoy salvage value
Hirer enjoys the salvage value of
the asset.
3) Entire lease rentals is tax
deductable for lease
Only interest component of hire
purchase installments is tax
deductable.
VENTURE CAPITAL
Venture capital plays a strategic role as a source of finance
especially in case of small scale, high technologies drivers and risky
ventures. It is a very populars concept in advanced countries and it is
gaining its importance in developing countries also.
Venture capital is considered as synonym of high risk capital.
A business organization involving in new, innovative, and risky
business/ project may not be able to get its financial requirements fulfilled
from any traditional sources. Therefore they approach a specialized
agency specially meant for financing such project. Such agencies are
called as venture capitalist or venture capital firm.
Venture capital is early stage financing of new and young
enterprises seeking to grow rapidly.
Features:
Venture capitalist or venture capital firm is inclined to assume a high
degree of risk for earning high return.
Venture Capital Firm (VCF) not only provides fund but also takes
active part in management.
Financial burden of assisted firm is negligible in first few years.
VCF normally plans to liquidate its investment in the assisted firm
after 3 – 7 years.
VCF normally invests in equity capital of assisted firm and tends to
invest for long term.
Stages in venture capital financing
1) Early stage financing
a) Seed financing for supporting a concept/ idea.
b) R & D financing for product development
c) Start up capital for initial production and marketing
d) First stage financing for full scale production and financing.
2) Expansion financing
a) Second stage financing for working capital and initial
expansion.
b) Development finance for facilitating public issue.
3) Acquisition / buyout finance
a) Acquisition finance to acquire new firm for further growth.
b) Turnaround financing for turning around a sick unit.
Venture capital investment process
Deal origination
Screening of the project
Detailed evaluation of projects:- It includes technical, marketing
and financial evaluation.
Post investment activity :- It includes providing technical and
management assistance and controlling the project.
Liquidating the investment or exit from the project.
Venture capital in India:
In Indian context venture capital gained importance in post
liberalization era. Various financial institutions like IDBI, IFCE, ICICI,
SFC’s, SIDBI and most of the commercial banks have set up their own
fully owned subsidiary company to carry on venture capital business.
Limitations of venture capital in India:
Inadequacy of equity capital financing by venture capitalists.
Focus on low risk ventures by venture capital firms.
Conservative approach followed by venture capital firms.
Delay in project evaluation by venture capital firms.
CREDIT RATING:
It is an old concept in USA. “It is essentially giving opinion by a
rating agency on the relative willingness and ability at the issuer of a debt
instrument to meet the debt servicing obligation in time and in full”.
In simple words it is a process where by a credit rating agency after
thorough analysis, gives its opinion about creditworthiness of the
company issuing debt instruments.
It helps the investors to analyze the risk associated with the debt
instruments.
Features
1) Specificity:- credit rating is done specifically to a particular debt
instrument.
2) Relativity:- It is based on the relative capability and willingness of
the issuer of the debt instruments to meet obligation.
3) Guidance: Credit rating is just a guidance given by the agency.
4) It is not a recommendation to buy the debt instruments.
5) It is based on the broad parameters.
6) No guarantee by credit rating agency on the debt instruments issued
by the company.
7) Uses both qualitative and quantitative information to give the
rating.
Advantages of credit rating
1) To investors
a) Provides information about the company and instrument.
b) It is a systematic risk evaluation.
c) Professional competency is used to give rating.
d) It is easy to understand
e) Lost of analysis will be less.
f) Efficient portfolio management can be done by credit norms
worth.
2) To Issuer (Company):
a) Credit ranking is an index of faith
b) It assists the company to have wider investors base.
c) It is a benchmark.
Key factors considered in credit rating:
i) Business analysis :- In includes nature or business, risk associated
with business growth prospects etc.
ii) Financial analysis: here it includes profitability, liquidity,
conditions, networth etc.
iii) Management evaluation:- Promoters, their credit worthiness, their
post tract records are analyzed.
iv) Regulatory and competitive environment:- Which includes
government regulations on the basis of competitions the business
etc.
v) Fundamental analysis:- It includes liquidity, profitability , interest
loan
SEBI and RBI guidelines on credit rating:
SEBI guidelines requires issue of debentures, bonds, convertibles,
or redeemable for a period beyond 18 months needs credit rating.
As per RBT guidelines issue of commercial papers requires credit
rating.
Credit rating agencies in India:
1) CRISIC(Credit Rating Information Services India Ltd.): Jointly set
up in 1988 by ICICI, UTI, LIC, GIC and few others financial
institutions. Head office at Mumbai most of the grading is done by
CRISIL.
2) ICRA (Investors Information and Credit rating agencies:- started in
1991 promoted by IFCI and others
3) Care (Credit analysis and Research Ltd):- set up in 1993 by IDBI
and other financial institutions.
4) Different and phase:- Set up in private sector in 1996.
Certain ranges of Crisil:-
AAA – Highest Security
AA – Limitations of credit rating
A – Adequate safety
BBB – Moderate safety
BB – Inadequate safety
B – High risk
C – Substantial risk
D – Default
There is a need to have a different credit rating for different
instruments like, debentures, bonds, medium term debt including FD’s
and short term debt instruments including commercial papers.
Limitations of credit rating:
No rating for equity
Only indicator of risk
Only opinion and no guarantee
Need to be updated frequently
Sources of working capital financing
1) Trade credits
Trade credits refers to the credit that the business firm gets from
supplier of goods in the normal course of business. It is usually on an
open account basis.
Advantages:-
Easily available
Flexibility
No formality
No cost
Implied cost:
When a credit period is offered there may be a discount offered by
the supplier. If the firm wants to avail the excess credit period they cannot
avail the discount and vice versa.
2) Accrued expenses and deferred income
Accrued expenses is the liability that the firm has to pay for the
service which it has already received. For example:- outstanding salary,
wages taxes, insurance etc.
Deferred income refers to income received in advance. Eg:-
advance payment by customer.
Both of these are the sources of financing working capital.
3) Bank finance:
Bank financing is one of the most important sources of working capital
financing. The bank finance can be availed in the following ways:
a) Bank overdraft and cash credit:-
Here the business firm is allowed to withdraw more than the
balance available in the bank account. The interest is charged only on the
withdrawn amount and not on the sanctioned amount. Incase of old no
security required where as some collateral is required in case of cash
credit.
b) Short term working capital loan: Loan for a period not exceeding
a year.
c) Term loan for working capital:
Especially for permanent working capital a term loan for a period
ranging between 3 – 7 years can be arranged.
d) Purchase or discounting of bills of exchange:-
Bankers discounts/ purchases the bill of business firm for a
discount.
e) Letter of credit (LOC):-
It is an indirect way of financing by banker. Here banker issues a
LOC to foreign supplier undertaking a guarantee to pay the money if the
customer fails to make the payment. On the basis of LOC business firms
can get trade credit especially from foreign suppliers.
Security required for bank finance
i) Hypothecation:-In case of movable assets, the property is
hypothecated to the banker, but physical possession remains with
the owner.
ii) Mortgage:- It is used in case of immovable assets physical
possession remains with borrower but, property cannot be sold
unless settling the loan to banker.
iii) Pledge:- In this case physical possession of the property is kept by
the banker on the loan given.
Regulations of bank finance:
Banks are following certain norms in granting credit. These norms are
influenced by reports of certain committees which are appointed by RBI.
Few of these committees includes.
i) Tandon committee report
This committee was appointed in July 1974, to suggest guidelines for
rational allocation and optimum use of bank credit. Recommendations of
this committee can be summed up as follows:
1) Operational plans:- Business firms need to give their operational
plans to get bank credit.
2) Production based finance:- Banks are required to finance only on
the banks of production activity by business firm.
3) Partial bank finance:-Banks should do only partial financing and
not full financing.
4) Fixing of inventory and receivable norms for business organization
requiring bank finance.
5) Banker is suppose to finance only working capital gap.
6) Fixation of maximum permissible bank finance (MPBF)
ii) Chore committee report:
In 1979, RBI has setup a committee under K.B. Chore. This committee
has given the following recommendations:
a) Reduction of dependence on banks as a source of finance.
b) Credit limit available to business firms should be separated
into peak level and normal level limits.
c) Existing system of cash credit, loans, bills discounting
should be continued.
d) Quarterly statement from business organization is needed by
the banks when the firm is borrowing more than RS. 50 lakhs
loan.
iii) Commercial papers (CP):
Commercial papers are important sources of short term financing.
It is form of financing consisting of short term unsecured promissory
notes issued by firms with a high credit rating. In India RBI introduced
commercial paper in 1989.
Features:
a) Commercial papers maturity period varies between 15 days –
1year.
b) Commercial papers sold at discount and redeemed at face value.
c) Investors of commercial papers includes, insurances companies,
banks, MF’s etc. but not individual investors.
d) Commercial papers directly sold to investors or through brokers.
e) There is no secondary market for commercial papers.
Commercial papers in India:
7) Regulated by RBI
8) Companies having a networth of RS. 10 crores and good credit
rating can issue commercial papers.
9) Minimum size of an issue is RS. 25 lakhs and each commercial
paper should be of more than Rs. 5 lakhs.
10) Maximum amount can be raised in upto 100% of working capital
unit.
11) Investors of commercial papers are bank LIC, UTI, NRI’s etc.
12) Holder of commercial papers is on maturity to the issuer and gets
the refund.
Effective yield on commercial papers/ cost of commercial papers
Face vale – net amount realized 365
-------------------------------------- x ------------------------------
Net amount realized maturity period ( in days)
Merits of commercial papers:
Alternative sources of financing to bank credit during tight bank
credit.
Cheaper than bank credit in some cases.
For investors it is a short term safe investment.
Limitations of commercial papers:
Not possible to extend the maturity
Can be issued by companies having good credit rating and financial
stability
Cannot be redeemed until maturity.
5) FACTORING
Debtor receivables arising out of credit sales are sold to a financial
institution called as factors at a discount.
It involves the outright sale of receivables at a discount to a factor
to obtain funds.
It provides a source of finance as well as facilitates the collection of
receivables.
It is an agreement in which receivables arising out of sale of
goods / services are sold by a firm to the factor (financial intermediary) as
a result of which title of goods represented by receivables passed on to the
factor. Factor becomes responsible for debt collection.
Types:
i) With reference:- If the factor is not able to collect the receivables
from the buyers/ debtors the loss has to be incurred by the firm and
not by factor
ii) Without recourse:- If factor cannot collect it is his loss and it
cannot be passed on to the firm.
Advantages
Ensures definite and continuous cash flows to the firms
No need for credit collection department.
Limitations:
a) High cost especially in case of without recourse.
b) Indicates financial weakness of the firm.
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