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UNIT â III: FINANCIAL MANAGEMENT
Business implies a commercial activity of producing and distributing goods and
services to final consumers for a profit. To undertake various business activities, an entity
requires money and thus, finance is said to be the spine of business that keeps it going.
The capital brought in, to the business by the proprietor is not sufficient to fulfil the
financial needs and so he/she looks for new ways to fulfil fixed capital and working capital
needs.
Fixed capital requirements
Funds are required to purchase fixed assets like land and building, plant and
machinery, and furniture and fixtures. This is known as fixed capital requirements of the
enterprise.
The funds required in fixed assets remain invested in the business for a long period
of time.
Different business units need varying amount of fixed capital depending on various
factors such as the nature of business, etc.
For example, a trading concern may require small amount of fixed capital as
compared to a manufacturing concern. Likewise, the need for fixed capital investment would
be greater for a large enterprise, as compared to that of a small enterprise.
Working capital requirements:
Funds required for day-to-day operations of an enterprise are known as working
capital.It is used for holding current assets such as stock of material, bills receivables and for
meeting current expenses like salaries, wages, taxes, and rent.
The amount of working capital required varies from one business concern to another
depending on various factors.
For example , A business unit selling goods on credit, or having a slow sales turnover,
would require more working capital as compared to a concern selling its goods and services
on cash basis or having a speedier turnover.
The requirement for fixed and working capital increases with the growth and
expansion of business.
Based on the source of generation, it is classified as internal and external sources ,
wherein former covers those means which are generated within the business.Conversely,
the latter implies the sources of funds that are generated outside the business like finance
provided by the investors, lending institutions etc.
Definition of Internal Sources of Finance
In business, internal sources of finance delineate the funds raised from existing
assets and day to day operations of the concern. It aims at increasing the cash generated
from regular business activities.
For this purpose, evaluation and control of costs are made, along with reviewing the
budget. Moreover, the credit terms with customers are verified, so as to effectively manage
the collection of receivables.
Internal sources of finance include selling of assets, ploughing back of profit
(retained earnings), and reduction in working capital.
Definition of External Sources of Finance
External sources of finance refer to the cash flows generated from outside sources of
the organization, whether from private means or from the financial market. In external
financing, the funds are arranged from the sources outside the business.
There are two types of external sources of finance, i.e. long term source of finance
and short term sources of finance. Further on the basis of nature, they can be classified as:
Equity Financing : Equity is the major source of finance for most of the companies which
indicate the share in the ownership of the firm and the interest of the shareholders. The
firms raise capital by selling its shares to the investors. It includes:
ďˇ Ordinary shares
ďˇ Preference shares
Debt financing : The source of finance wherein fixed payment has to be made to the lenders
is debt financing. It includes:
Used for Internal sources are generally used for funding day-to-day business operations. High-profit making entities can however use these for growth plans as well if the funds generated are sufficient. External sources are generally used for setting up a business or at later stages for growth and expansion , when funds generated from internal operations do not suffice. Loss making companies may also use these sources for business revival or to keep their operations going. Process for obtaining Raising funds from internal sources generally do not involve any formal process. It is a more automatic process where funds generated from business operations are re-applied in the business. Raising funds from external involves a more structured and formal process. This includes deliberation of the management, Director and shareholder resolutions, holding meetings with financers, discussing terms and finalizing documentation Parties involved Raising funds through internal sources generally does not involve any third party except where business assets are sold to generate funds. Raising funds through external sources necessarily involves one or more external third parties. Tax benefits Internal sources of finance do not have any specific tax benefits. External sources of finance may involve incurring of tax-deductible financing costs such as interest. This can help reduce tax incidence on profits of the entity. Conclusion â internal vs external sources of finance The choice of source of finance depends on several parameters. Probably the first and foremost, being the quantum of finance required. Where sufficient funds can be generated through internal sources, entities may prefer it as it is simpler and generally less expensive than seeking external sources. However, where these funds are not sufficient for the business requirements, businesses have to turn to outside entities to raise funds. Tax considerations may also make entities choose between internal and external sources of finance.
Retained Earnings:
A company generally does not distribute all its earnings amongst the shareholders as dividends. A portion of the net earnings may be retained in the business for use in the future. This is known as retained earnings. It is a source of internal financing or selffinancing or âploughing back of profitsâ. The profit available for ploughing back in an organisation depends on many factors like net profits, dividend policy and age of the organisation.
Sale of Assets:
Another internal source of finance is the sale of assets. Whenever business sells off its assets and the cash generated is used internally for financing the capital needs, we call it an internal source of finance by the sale of assets.
Reduction of Working capital:
It is interesting to know how a reduction in working capital can work as an internal source of finance. Working capital has broadly two components. One, Current Assets, which include Stock / Inventory, Account Receivables â Debtors and Cash / Bank Balances. Second, Current Liabilities, which include Account Payables â Creditors and Bank Overdraft. Normally, a business requires two types of finance viz. long-term finance for capital expenditure and working capital finance for day to day needs. Reduction in working capital can be achieved either by speeding up the cycle of account receivables and stock or by lengthening the cycle of account payables. In essence, both will reduce the working capital requirement and therefore the funds invested for working capital can be utilized for the other finance or capital requirements. This source has a little different analytics. This source is generated out of the efficient management of working capital and appropriate usage of working capital management techniques.
Trade Credit:
Trade credit is the credit extended by one trader to another for the purchase of goods and services. Trade credit facilitates the purchase of supplies without immediate payment. Such credit appears in the records of the buyer of goods as âsundry creditorsâ or âaccounts payableâ. Trade credit is commonly used by business organisations as a source of short-term financing. It is granted to those customers who have reasonable amount of financial standing and goodwill. The volume and period of credit extended depends on factors such as reputation of the purchasing firm, financial position of the seller, volume of purchases, past record of payment and degree of competition in the market. Terms of trade credit may vary from one industry to another and from one person to another. A firm may also offer different credit terms to different customers.
Lease Financing:
A lease is a contractual agreement whereby one party i.e., the owner of an asset grants the other party the right to use the asset in return for a periodic payment. In other words, it is a renting of an asset for some specified period.
The person holding the share is known as shareholder. There are two types of shares normally issued by a company. These are equity shares and preference shares. The money raised by issue of equity shares is called equity share capital, while the money raised by issue of preference shares is called preference share capital. Equity Shares: Equity shares is the most important source of raising long term capital by a company. Equity shares represent the ownership of a company and thus the capital raised by issue of such shares is known as ownership capital or ownerâs funds. Equity share capital is a prerequisite to the creation of a company. Equity shareholders do not get a fixed dividend but are paid on the basis of earnings by the company. They are referred to as âresidual ownersâ since they receive what is left after all other claims on the companyâs income and assets have been settled. They enjoy the reward as well as bear the risk of ownership. Their liability, however, is limited to the extent of capital contributed by them in the company. Further, through their right to vote, these shareholders have a right to participate in the management of the company. Preference Shares: The capital raised by issue of preference shares is called preference share capital. The preference shareholders enjoy a preferential position over equity shareholders in two ways: (i) receiving a fixed rate of dividend, out of the net profits of the company, before any dividend is declared for equity shareholders; and (ii) receiving their capital after the claims of the companyâs creditors have been settled, at the time of liquidation. In other words, as compared to the equity shareholders, the preference shareholders have a preferential claim over dividend and repayment of capital. Preference shares resemble debentures as they bear fixed rate of return. Also as the dividend is payable only at the discretion of the directors and only out of profit after tax, to that extent, these resemble equity shares. Thus, preference shares have some characteristics of both equity shares and debentures. Preference shareholders generally do not enjoy any voting rights. A company can issue different types of preference shares
Debentures:
Debentures are an important instrument for raising long term debt capital. A company can raise funds through issue of debentures, which bear a fixed rate of interest. The debenture issued by a company is an acknowledgment that the company has borrowed a certain amount of money, which it promises to repay at a future date. Debenture holders are, therefore, termed as creditors of the company.
Debenture holders are paid a fixed stated amount of interest at specified intervals say six months or one year. Public issue of debentures requires that the issue be rated by a credit rating agency like CRISIL (Credit Rating and Information Services of India Ltd.) on aspects like track record of the company, its profitability, debt servicing capacity, credit worthiness and the perceived risk of lending. A company can issue different types of debentures. Issue of Zero Interest Debentures (ZID) which do not carry any explicit rate of interest has also become popular in recent years. The difference between the face value of the debenture and its purchase price is the return to the investor. Difference between Shareholder and Debenture holder
For a company, there are two different ways through which it can raise funds - by
issuing shares or by issuing debt instruments. Though the end goal of both of these methods
is same, there are many fundamental differences exist between these two methods. In this
session, weâre going to look at the differences between shareholders and debenture
holders.
Who are shareholders?
As the name itself implies, anybody who owns the shares of a company is termed as
a shareholder. Since they own parts of the company, shareholders are widely referred to as
owners of the company.
Who are debenture holders?
Debenture is a kind of debt instruments used by companies to raise funds. A company can
raise funds through issue of debentures, which bear a fixed rate of interest. The debenture
issued by a company is an acknowledgment that the company has borrowed a certain
amount of money, which it promises to repay at a future date. Debenture holders are,
therefore, termed as creditors of the company.
What is the difference between a shareholder and debenture holder?
As you can see by now, shareholders and debenture holders are fundamentally different.
That said, their differences extend far beyond just being the holders of their respective
instruments. Hereâs a quick look at a few of the differences between these two types of
holders.
Shareholders Debenture holders
Shareholders are the owners of the company.
Debenture holders are merely lenders to the
company and are considered to be creditors.
