LESSON -2 Finance functions

Investment Decision

One of the most important finance functions is to intelligently allocate capital to long term assets. This activity is also known as capital budgeting. It is important to allocate capital in those long term assets so as to get maximum yield in future. Following are the two aspects of investment decision

1. Evaluation of new investment in terms of profitability
2. Comparison of cut off rate against new investment and prevailing investment.

Since the future is uncertain therefore there are difficulties in calculation of expected return. Along with uncertainty comes the risk factor which has to be taken into consideration. This risk factor plays a very significant role in calculating the expected return of the prospective investment. Therefore while considering investment proposal it is important to take into consideration both expected return and the risk involved.

Investment decision not only involves allocating capital to long term assets but also involves decisions of using funds which are obtained by selling those assets which become less profitable and less productive. It wise decisions to decompose depreciated assets which are not adding value and utilize those funds in securing other beneficial assets. An opportunity cost of capital needs to be calculating while dissolving such assets. The correct cut off rate is calculated by using this opportunity cost of the required rate of return (RRR)

Financial Decision

Financial decision is yet another important function which a financial manger must perform. It is important to make wise decisions about when, where and how should a business acquire funds. Funds can be acquired through many ways and channels. Broadly speaking a correct ratio of an equity and debt has to be maintained. This mix of equity capital and debt is known as a firm’s capital structure.

A firm tends to benefit most when the market value of a company’s share maximizes this not only is a sign of growth for the firm but also maximizes shareholders wealth. On the other hand the use of debt affects the risk and return of a shareholder. It is more risky though it may increase the return on equity funds.

A sound financial structure is said to be one which aims at maximizing shareholders return with minimum risk. In such a scenario the market value of the firm will maximize and hence an optimum capital structure would be achieved. Other than equity and debt there are several other tools which are used in deciding a firm capital structure.

Dividend Decision

Earning profit or a positive return is a common aim of all the businesses. But the key function a financial manger performs in case of profitability is to decide whether to distribute all the profits to the shareholder or retain all the profits or distribute part of the profits to the shareholder and retain the other half in the business.

It’s the financial manager’s responsibility to decide a optimum dividend policy which maximizes the market value of the firm. Hence an optimum dividend payout ratio is calculated. It is a common practice to pay regular dividends in case of profitability .another way is to issue bonus shares to existing shareholders.

Liquidity Decision

It is very important to maintain a liquidity position of a firm to avoid insolvency. Firm’s profitability, liquidity and risk all are associated with the investment in current assets. In order to maintain a tradeoff between profitability and liquidity it is important to invest sufficient funds in current assets. But since current assets do not earn anything for business therefore a proper calculation must be done before investing in current assets.

Current assets should properly be valued and disposed of from time to time once they become non profitable. Currents assets must be used in times of liquidity problems and times of insolvency.

Sources of Finance:

The primary responsibility of financing a business venture is that of the owners of the business. However, loans and credits also meet the financial requirements of business firms. In sole proprietorship business, the indi­vidual proprietor generally, invests her/his own savings to start with.

She/he may reinvest a part of the profits earned in course of time. She/he may also borrow money on her/his personal security or the security of assets. Similarly, the capital of a partnership firm consists partly of funds contrib­uted by the partners and partly of borrowed funds. If necessary, they may also decide to reinvest their own shares of profit.

The company form of organization enables the promoters to raise necessary funds from the public, who may contribute capital and become shareholders of the com­pany. In course of its business, the company can raise loans directly from banks’ and financial institutions or by issue of debentures to the public. Besides, profits earned may also be reinvested instead of being distributed as dividend to the shareholders.

Thus, for any business enterprise, there are two sources of finance, that is, funds contributed by owners, and funds available from loans and credits. In other words, the financial resources of a business may be provided by owners funds and borrowed funds.

Sources of Company Finance:

The sources of long term finance include:

(i) Issue of shares;

(ii) Issue of debentures;

(iii) Loans from financial institutions;

(iv) Retained profits; and

(v) Public deposits.

(i) Issue of Shares:

The amount of capital decided to be raised from members of the public is divided into units of equal value. These units are known as shares and the aggregate value of shares is known as share capital of the company. Those who subscribe to the share capital become members of the company and are called shareholders. They are the part owners of the company. Hence, shares are also described as ownership securities.

Two types of shares may be issued by a company to raise capital:

(a) Equity shares; and

(b) Preference shares.

(a) Equity shares:

The amount raised by the issue of equity shares is known as equity share capital, it is the most important source of raising long term capital for a company. Equity capital represents ownership capital as equity shareholders collectively own the company. They enjoy the reward as well as bear the risk of ownership. There is no promise to shareholders of a fixed dividend.

The liability is generally, limited to the amount agreed to be subscribed by the shareholders. Equity share capital may be (i) with equal rights; or (ii) with differential rights as to dividend, voting or otherwise. This has been permitted after an amendment to the Companies Act in 2000. Prior to this, public companies were not allowed to issue equity shares with differential rights.

Equity shares have the following distinct characteristics:

(i) The holders of equity shares are the primary risk bearers. It is the issue of equity shares that mainly provides risk capital. This implies that in case the company suffers losses and has to be closed down, the equity shareholders may lose the entire amount they had invested. Creditors’ dues must be met before any payment is made to the preference or equity shareholders.

(ii) Equity shareholders have a residual claim in the firm. In other words, the income left after satisfying the claims of all creditors, outsiders, and preference shareholders, belongs to equity shareholders.

(iii) Equity shareholders are likely to enjoy a higher profit as well as higher increase in the value of the shares.

(iv) Equity share capital is the basis on which loans can be raised. It provides credibility to the company and confidence to the loan providers.

(v) Since equity shareholders have the right to vote for the election of the board of directors, collectively they ensure that the company is managed in the best interests of the shareholders.

Merits:

From the company’s point of view, there are several merits of issuing equity shares to raise long term finance:

(i) It is a source of permanent capital without any commitment of a fixed return to the shareholders. The return on capital depends ultimately on the profitability of business.

(ii) It facilitates a higher rate of return to be earned with the help of borrowed funds because loans carry a fixed rate of interest. Hence, equity shareholders are likely to enjoy a higher rate of return based on profitability.

(iii) It is on the basis of equity share capital that loans can be raised. Equity provides the credibility to the company and confidence to the prospective loan provider.

(iv) Democratic control over management of the company is assured due to the voting rights of equity shareholders.

Limitations:

Although there are several advantages of issuing equity shares to raise long term capital, there are certain limitations also of this source of finance:

(i) Equity shares have the risk of fluctuating returns and the risk of fluctuating market value of shares. In times of adversity, there may be low returns or even no returns.

(ii) Equity share capital is a permanent source of finance. It cannot be refunded during the life of the company. When there is no scope for expansion or new investment during periods of economic depression, the equity capital may remain idle, the rate of return may be reduced since there is no commitment to pay and no fixed obligations to be met on equity capital, there is always the possibility of putting it to sub optimal uses.

(iii) Issue of additional equity shares to raise funds for expansion poses a threat to the existing shareholders as regards their power of control over management of the company. Existing shareholders are generally, offered the new issue of shares and in case they decline, the shares are offered to the public. New shareholders may exercise their voting rights against the continuation of existing directors.

(iv) There are too many procedural delays and too many time consuming formalities to be completed before any public issue of shares can be made.

(v) An equity issue cannot be made any time the company wants. It depends on market conditions.

These generally determine the time of issue of shares and the value of the shares. A new variant of equity shares that have recently been introduced are sweat equity shares. These are shares issued at discount or for con­sideration other than cash, for providing know-how or intellectual property rights or value additions.

(b) Preference shares:

The amount of share capital which is raised by the issue of preference shares is called preference share capital. It is referred to as preference shares as the owners of these shares have a preferential claim over dividends and repayment of capital. Preference shares represent a hybrid form of financing in that, it consists of some characteristics of equity shares and some attributes of debentures.

It resembles equity shares in the following ways:

(i) Preference dividend is payable only out of profit after tax;

(ii) The payment of preference dividend is entirely within the discretion of directors. It is not an obligatory payment, even if there is a profit. It resembles debentures because it gets a fixed rate of return.

Preference shares have the following distinct characteristics:

(i) Preference shareholders have the right to claim dividend out of profits at the fixed rate, which is decided according to the terms of issue of shares.

(ii) Preference shareholders have also the preferential right of claiming repayment of capital in the event of winding up of the company. Preference capital has to be repaid out of assets after meeting the loan obligations and claims of creditors but before any amount is repaid to equity shareholders.

Different kinds of preference shares may be issued as:

(a) Cumulative or non-cumulative;

(b) Participating or non-participating;

(c) Redeemable or non-redeemable;

(d) Convertible cumulative preference shares.

In the case of cumulative preference shares, if dividend cannot be paid due to inadequate profits in a particular year, the arrears of dividend accumulate and become payable in subsequent years when profits are adequate. Non-cumulative preference shares have no such provision.

If the shareholders, in addition to the fixed rate of dividend, are entitled to a further share in the surplus profits after a reasonable dividend has been paid to equity shareholders, the shares are known as participating preference shares.

Where the terms of issue do not provide for it, the shares are known as non-participating preference shares. Redeemable preference shares are those which the company undertakes to redeem (that is, repay) after a specified period.

Where there is no such undertaking, the shares are called irredeemable preference shares. However, these shares can also be redeemed by the company after specified period by giving notice as per the term of issue. It may be noted that companies are no longer permitted to issue irredeemable preference shares.

A company may decide to issue a type of cumulative preference share which can be converted into equity share. These are known as convertible cumulative preference shares. Under present rules in India conversion of such shares can be decided to be made between the end of one and five years. In India preference shares usually are cumulative with reference to dividends.

Merits:

Issue of preference shares as a source of finance is preferred by many companies due to the following reasons:

(i) It helps to enlarge the sources of funds as some financial institutions and individuals prefer to invest in preference shares due to the assurance of a fixed return. This helps the company to attract investors.

(ii) Dividend is payable only when there are profits. There are no fixed liabilities as is the case with loans and borrowings.

(iii) A higher return is possible if the company is in good times, in the case of participating preference shares.

(iv) It does not affect the equity shareholders control over management.

(v) The rate of preference dividend is fixed. Hence, in years of prosperity, the rate of return on equity capital is likely to be higher than it would be otherwise, due to preference share capital.

Limitations:

The limitations of preference shares relate to some of its main features:

(i) Dividend paid cannot be charged to the company’s income as an expense; hence, there is no tax saving as in the case of interest on loans.

(ii) Issue of preference share does not attract many investors as there is no assured return, and the return is generally, low and lesser than the rate of interest on loan.

(iii) The holders of preference shares have a right to vote on any resolution of the company directly affecting their rights, which includes any resolution for winding up the company, repayment or reduction of its share capital, etc.

(ii) Debentures:

Debentures are instruments for raising long term debt capital. When a company decides to raise loans from the public, the amount of loan raised from a particular issue of debentures is divided into units of similar value. A debenture certificate is issued by the company to acknowledge its debt.

Those who invest money in debentures are known as debenture holders. They are creditors of the company. Debentures are, therefore, called creditor-ship securities.

Debentures have the following characteristics:

(a) Debentures carry a fixed rate of interest.

(b) Debentures are redeemable i.e., repayable after a certain period which is specified at the time of issue. They may become due for repayment after a period of five years or more.

(c) When debentures are sold to the public and involve a considerable number of persons, a trustee is appointed and a trust deed is formed to convey the property of the company to her/him.

The trustee is usually a bank, an insurance company or a financial institution. The trustee is appointed to ensure that the borrowing firm fulfills its contractual obligations. Depending upon the terms and conditions of issue there are different types of debentures.

These are secured or unsecured debentures, and convertible or non-convertible debentures:

(i) Debentures which are secured by a charge on the immovable properties, of the company are secured debentures. Debentures which are not secured by a charge or mortgage of any asset are called unsecured debentures. The holders of these debentures are treated as ordinary creditors.

(ii) A company may issue debentures which are convertible into equity shares at the option of debenture holders. The ratio of conversion and the period during which conversion can be effected are specified at the time of debenture issue. Such debentures are known as convertible debentures.

If there is no mention of conversion at the time of issue, the debentures are regarded as non-convertible debentures.

Merits:

Debenture issue is a widely used method of raising long term finance by companies. This is due to the following merits:

(i) The cost of debt capital, represented by debentures is lower than the cost of preference or equity capital. This is because the interest on debentures is tax deductible and, hence, it helps in increasing the rate of return. Thus, debenture issue is a cheaper source of finance.

(ii) Debenture financing does not result in dilution of control of equity shareholders, since debenture holders are not entitled to vote.

(iii) The fixed monetary payment associated with debentures is interest. This fixed return appeals to many investors, since they are not affected by the fluctuating fortunes of the company.

(iv) Funds raised by the issue of debentures may be used in business to earn a much higher rate of return than the rate of interest. As a result, the equity shareholders earn more.

Limitations:

We have noted above the advantages of debenture issue as a source of finance.

But, it has certain limitations also:

(i) It involves a fixed commitment to pay interest regularly and fixed obligation to pay the amount when it is due on the part of the company.

(ii) This liability must be discharged even if the company has no earnings. The burden may be difficult to bear in times of falling profits.

• Retained profits:

Retained earnings are the undistributed profits after payment of dividends and taxes, commonly referred to as reserves and surplus. They represent the internal sources of finance available to the company. The company’s use of surplus or free reserves, is termed as ploughing back of profits. It provides the basis of financial expansion and growth of companies. It is considered as a very important source of funding. Since it is internally generated, this method of financing is known as self-financing.

The retained earnings serve many purposes:

(a) They provide a cushion of security in times of adversity, which the company can fall back upon.

(b) In certain industries such as pharmaceuticals research and development activities are of vital importance. Constant innovation and new products are essential for survival. Funds for these purposes can be available out of retained profits.

(c) Finance for new projects and expansion plans are sometimes required to enter new forays which are important areas for the future. Retained profits prove useful such times. Since profits belong to the shareholders, retained profit is considered to be an ownership fund. It serves the purpose of medium and long term finance.

The total amount of ownership capital of a company can be determined by adding the share capital and accumulated reserves. Companies may convert reserves and surplus into share capital by issuing bonus shares. From the company viewpoint, bonus shares are issued free of cost and do not result in any outflow of cash. Investors too are benefited by the issue of shares free of cost.

Merits:

This source of finance has the following advantages:

(i) As an internal source, it is more dependable than external sources. It does not depend on the investors’ preference and market conditions.

(ii) Use of retained profit does not involve any cost to be incurred for raising the funds. There are no expenses on prospectus, advertising, etc.

(iii) There is no fixed commitment to pay dividend on such funds.

(iv) Control over the management of the company remains unaffected as there is no addition to the number of shareholders.

(v) Unlike debentures, no charge is created against the assets and no restrictions are put on the management.

(vi) Retained earnings add to the financial strength and improved credibility of the company. A company with large reserves can face unforeseen contingencies, trade cycles and any other crisis.

Limitations:

Use of retained earnings may result in the following drawbacks:

(i) The management of a company may not always use the retained earnings in the best interest of shareholders. It may misuse them by investing in unprofitable or undesirable channels. Excessive reserves may make the management wasteful and extravagant.

(ii) Large retention of earnings over a long period of time may cause dissatisfaction among shareholders as they do not receive the expected rate of dividend.

(iii) If the quantum of retained earnings is too high, the management may issue bonus shares to equity shareholders. Frequent capitalisation of reserves may result in over capitalisation.

• Public deposits:

 These are unsecured deposits invited by companies from the public mainly to finance working capital requirements. Public deposits can be invited by companies for a period of 6 months to 3 years as per rules. However, they can be renewed from time to time.

Though, they are primarily sources of short term finance, the renewal facility enables them to be used as medium term finance. Fixed deposits are simple to raise. A company intending to invite deposits simply has to advertise in the newspapers. Any member of the public can fill up the prescribed form and deposit the money with the company.

The company in return issues a deposit receipt which is an acknowledgement of debt by the company. The terms and conditions of the deposit are printed on the back of the receipt. Earlier interest rates were subject to a ceiling. But now, interest rates are in tune with the market trends, but generally, public deposits pay out a higher rate than the interest rate on bank deposits.

The rate of interest on public deposits depends on the period of deposit and reputation of the company. Since these deposits are unsecured, a company that has public deposits is required to set aside, as deposit or investment, in the current year an amount equal to 10 per cent of the deposits maturing by the end of the year.

The amount so set aside can be used only for repaying such deposits. Public deposits cannot exceed 25 per cent of share capital and free reserves.

Merits:

The merits of public deposits are the following:

(i) The procedure for obtaining public deposits is much simpler than equity and debenture issues. Thus, there are fewer administrative costs for deposits.

(ii) Public deposits are unsecured. Thus, the assets are free to be used as mortgage in future, if need arises.

(iii) Interest paid on public deposits is tax deductible. Hence, it helps in bringing down the tax liability.

(iv) Public deposits introduce flexibility in the financial structure of the company. This is because the deposits can be repaid when they are not required.

(v) There is no dilution of shareholders’ control because the depositors have no voting rights.

Limitations:

Raising finance through public deposits suffers from the following limita­tions:

(i) The amount of funds that can be raised by way of public deposits is limited because of legal restrictions.

(ii) Since the maturity period is relatively short, the company cannot depend on them for long term financing requirements.

(iii) Public deposits are an uncertain and unreliable source of finance. The depositors may not respond when conditions in the economy are uncertain. Also, deposits may be withdrawn whenever the depositors feel shaky about the financial health of the company.

International Sources of Finance:

Prior to 1991, the Indian financial system was isolated from the interna­tional financial markets. Indian companies could only access the Indian capital markets, that is, their sources of finance were restricted within India. With the advent of economic liberalisation, an openness was intro­duced in the financial system.

Indian companies now have the option of accessing the global capital markets. They can tap international sources of finance for both debt and equity. The main instruments used by Indian companies to tap international sources of equity are Global Depository Receipts (GDRs) and American Depository Receipts (ADRs).

Global Depository Receipts (GDRs):

GDRs are issued to tap the global capital markets by way of global equity offerings. However, these are indirect equity offerings and the shares issued by the firm are held by an international bank referred to as a depository. This bank receives dividends, notices and reports and issues negotiable certificates as claims against these shares.

These claims are the GDRs and such shares are depository shares. GDRs are non-voting equity holdings. In short, GDRs are dollar-denominated instruments, usually rep­resenting a certain number of equity shares denominated in rupees.

American Depository Receipts (ADRs):

ADRs are similar to GDRs as they too are used to tap overseas investors. Like GDRs, they are global equity offerings. Like GDRs the shares issued by the company are held by an international bank (the depository), which receives dividends, notices, and reports. Though GDRs and ADRs are similar in many respects but they also have their points of difference.

ADRs carry more clout with investors as they are listed on one of the major stock exchanges in the US. Since stock exchange regulations are extremely stringent in the US, ADRs are subject to much stricter disclosure require­ments than GDRs. Also the annual legal and accounting costs of main­taining an ADR are much higher.

Foreign Direct Investment (FDI):

International finance also comes in the form of foreign direct investment (FDI). This is direct contribution to the equity capital of the company by multinational companies. Investment in the overseas operation of the MNCs is represented by foreign direct investment.

It includes:

(i) Investment for establishment of a new enterprise in foreign country either as a branch or as a subsidiary;

(ii) Expansion of an overseas branch or subsidiary; and

(iii) Acquisition of an overseas enterprise.

Institutional Finance:

Institutional finance refers to institutional sources of finance to industry, other than commercial banks. These financial institutions or financial in­termediaries act as a link between savers and investors, but are distinct from commercial bunks. These financial institutions offer finance and financial services in areas which are outside the purview of traditional commercial banking.

The term institutional finance generally includes:

1. Finance provided by Public Financial Institutions (PFIs);
2. Finance provided by Non-Banking Financial Companies (NBFCs);
3. Finance provided by Investment Trusts and Mutual Funds (ITMF).

Public Financial Institutions:

Public financial institutions are also referred to as term lending institutions, development banks or simply ‘financial institutions. After India attained independence, it was realised that specialised institutions were needed to accelerate development of the country.

Thus, development banks were established with the core objective of financing projects, aimed at bringing rapid industrialisation and cater to the long term financing needs of the industrial sector. Development banks differ from commercial banks in several respects.

In fact, they had to be established because of the inad­equacies of the existing financial intermediaries and banking institutions. Commercial banks provide credit for short term requirements. They focus on the working capital need of trade and industry.

Development banks provide finance for medium and long term needs. As the name suggests, the entire focus of these banks is the development of industrial units with the ultimate aim of industrial development of the country.

For this reason, they provide finance for investment in fixed assets, for expansion, diversi­fication and modernisation etc. Commercial banks are security oriented. Development banks are project oriented.

A project which has the potential of promoting an industrial structure conforming to national priorities, such as location in backward area, encouragement to new entrepreneurs, pro­motion of balanced regional development are favourably considered by development banks despite their long gestation periods. In India, the term public financial institution includes a large number of institutions.

A few are listed below:

(i) Industrial Credit and Investment Corporation of India Limited (ICICI);

(ii) Industrial Finance Corporation of India (IFCI Ltd.);

(iii) Industrial Development Bank of India (IDBI);

(iv) Unit Trust of India (UTI);

(v) Life Insurance Corporation of India (LIC);

(vi) National Housing Bank (NHB);

(vii) State Financial Corporations (SFCs).

The types of financial assistance provided by public financial institutions are as follows:

(i) They provide medium and long term finance to’ industrial enterprises at a reasonable rate of interest. Thus, companies may obtain direct loan from the financial institutions for expansion or modernisation of existing manufacturing units or for starting a new unit.

(ii) Often financial institutions subscribe to the debenture issue of companies.

(iii) Some of the institutions also subscribe to the shares issued by companies.

(iv) Financial institutions underwrite the public issue of shares and debentures by companies.

(v) They guarantee loans, which may be raised by industrial enterprises from other banks and financial institutions.

(vi) Loans in foreign currency may also be granted for the import of machinery.

(vii) The institutions stand guarantee for purchase of capital goods from foreign countries.

Non-Banking Financial Companies (NBFCs):

Recently, non-banking financial companies (NBFCs) have emerged as a significant sector of institutional finance. NBFCs are financial institutions which have diversified their activities to cater to specific financial services to include areas not covered by other institutions.

NBFCs when compared to commercial and cooperative banks are a heterogeneous group of finance companies. Thus, NBFCs engage in a variety of fund based as well as non-fund based activities. Fund based activities are those which involve finance. Non-fund based activities are fee based activities i.e., advisory services.

Depending on their nature and type of service provided, fund based NBFCs are categorised as one of the following:

(i) Leasing company;

(ii) Hire purchase company;

(iii) Housing finance company;

(iv) Venture capital fund.

The main non-fund based activities include:

(i) Issue management;

(ii) Corporate counseling;

(iii) Forex advisory services;

(iv) Credit rating;

(v) Portfolio management.

NBFCs are a significant part of the financial system. They broaden the range of financial services to include areas not covered by other institu­tions. Some prominent NBFCs are Kotak Mahindra Finance, SBI Capital Markets and Infrastructure Leasing and Finance Corporation.

Financing of Short-Term finance :

1. Indigenous Bankers: Private money-lenders and other country bankers used to be the only source of finance prior to the establishment of commercial banks. They used to charge very high rates of interest and exploited the customers to the largest extent possible. Now-a-days with the development of commercial banks they have lost their monopoly.

But even today some business houses have to depend upon indigenous bankers for Obtaining loans to meet their working capital requirements.

2. Trade Credit:

Trade credit refers to the credit extended by the suppliers of goods in the normal course of business. As present day commerce is built upon credit, the trade credit arrangement of a firm with its suppliers is an important source of short-term finance.

The credit-worthiness of a firm and the confidence of its suppliers are the main basis of securing  trade credit. It is mostly granted on an open account basis

whereby supplier sends goods to the buyer for the payment to be received in future as per terms of the sales invoice. It may also take the form of bills payable whereby the buyer signs a bill of exchange payable on a specified future date.

When a firm delays the payment beyond the due date as per the terms of sales invoice, it is called stretching accounts payable. A firm may generate additional short-term finances by stretching accounts payable, but it may have to pay penal interest charges as well as to forgo cash discount. If a firm delays the payment frequently, it adversely affects the credit worthiness of the firm and it may not be allowed such credit facilities in future.

The main advantages of trade credit as a source of short-term finance include:

• It is an easy and convenient method of
• It is flexible as the credit increases with the growth of the
• It is informal and spontaneous source of

However, the biggest disadvantage of this method of finance is charging of higher prices by the suppliers and loss of cash discount.

3. Installment Credit:

This is another method by which the assets are purchased and the possession of goods is taken immediately but the payment is made in installments over a pre- determined period of time. Generally, interest is charged on the unpaid price or it may be adjusted in the price. But, in any case, it provides funds for some time and is used as a source of short-term working capital by many business houses which

have difficult fund position.

4. Advances:

Some business houses get advances from their customers and agents against orders and this source is a short-term source of finance for them. It is a cheap source of finance and in order to minimize their investment in working capital, some firms

having long production cycle, specially the firms manufacturing industrial products

prefer to take advances from their customers.

5. Factoring or Accounts Receivable Credit:

Another method of raising short-term finance is through accounts receivable credit offered by commercial banks and factors. A commercial bank may provide finance by discounting the bills or invoices of its customers.

Thus, a firm gets immediate payment for sales made on credit. A factor is a financial institution which offers services relating to management and financing of debts arising out of credit sales. Factoring is becoming popular all over the world on account of various services offered by the institutions engaged in it.

Factors render services varying from bill discounting facilities offered by commercial banks to a total takeover of administration of credit sales including maintenance of sales ledger, collection of accounts receivables, credit control and protection from bad debts, provision of finance and rendering of advisory services to their clients. Factoring may be on a recourse basis, where the risk of bad debts is borne by the client, or on a non-recourse basis, where the risk of credit is borne by the factor.

At present, factoring in India is rendered by only a few financial institutions on a recourse basis. However, the Report of the Working Group on Money Market (Vaghul Committee) constituted by the Reserve

Bank of India has recommended that banks should be encouraged to set up factoring divisions to provide speedy finance to the corporate entities.

In-spite of many services offered by factoring, it suffers from certain limitations. The most critical fall outs of factoring include;

• The high cost of factoring as compared to other sources of short-term finance,
• The perception of financial weakness about the firm availing factoring services, and
• Adverse impact of tough stance taken by factor, against a defaulting buyer,

Upon the borrower resulting into reduced future sales.

6. Accrued Expenses:

 Accrued expenses are the expenses which have been incurred but not yet due and hence not yet paid also. These simply represent a liability that a firm has to pay for the services already received by it. The most important items of accruals are wages and salaries, interest, and taxes.

Wages and salaries are usually paid on monthly, fortnightly or weekly basis for the services already rendered by employees. The longer the payment-period, the greater is the amount of liability towards employees or the funds provided by them. In the same manner, accrued interest and taxes also constitute a short-term source of finance.

Taxes are paid after collection and in the intervening period serve as a good source of finance. Even income-tax is paid periodically much after the profits have been earned. Like taxes, interest is also paid periodically while the funds are used continuously by a firm. Thus, all accrued expenses can be used as a source of finance.

The amount of accruals varies with the change in the level of activity of a firm. When the activity level expands, accruals also increase and hence they provide a spontaneous source of finance. Further, as no interest is payable on accrued expenses, they represent a free source of financing.

However, it must be noted that it may not be desirable or even possible to postpone these expenses for a long period. The payment period of wages and salaries is determined by provisions of law and practice in industry.

Similarly, the payment dates of taxes are governed by law and delays may attract penalties. Thus, we may conclude that frequency and magnitude of accruals is beyond the control of managements. Even then, they serve as a spontaneous, interest free, limited source of short-term financing.

7. Deferred Incomes: Deferred incomes are incomes received in advance before supplying goods or services. They represent funds received by a firm for which it has to supply goods or services in future. These funds increase the liquidity of a firm and constitute an important source of short-term finance. However, firms having great demand for its products and services, and those having good reputation in the market can

demand deferred incomes.

8. Commercial Paper: Commercial paper represents unsecured promissory notes issued by firms to raise short-term funds. It is an important money market instrument in advanced countries like U.S.A. In India, the Reserve Bank of India introduced commercial paper in the Indian money market on the recommendations of the Working Group on Money Market (Vaghul Committee).

But only large companies enjoying high credit rating and sound financial health can issue commercial paper to raise short-term funds. The Reserve Bank of India has laid down a number of conditions to determine eligibility of a company for the issue of commercial paper. Only a company which is listed on the stock exchange, has a net worth of at least Rs 10 crores and a maximum permissible bank finance of Rs 25 crores can issue commercial paper not exceeding 30 per cent of its working capital limit.

The maturity period of commercial paper, in India, mostly ranges from 91 to 180 days. It is sold at a discount from its face value and redeemed at face value on its

maturity. Hence, the cost of raising funds, through this source, is a function of the amount of discount and the period of maturity and no interest rate is provided by the Reserve Bank of India for this purpose.

Commercial paper is usually bought by investors including banks, insurance companies, unit trusts and firms to invest surplus funds for a short-period. A credit rating agency, called CRISIL, has been set up in India by ICICI and UTI to rate commercial papers.

Commercial paper is a cheaper source of raising short-term finance as compared to the bank credit and proves to be effective even during period of tight bank credit. However, it can be used as a source of finance only by large companies enjoying high credit rating and sound financial health. Another disadvantage of commercial paper is that it cannot be redeemed before the maturity date even if the issuing firm

has surplus funds to pay back.

9. Working Capital Finance by Commercial Banks:

Commercial banks are the most important source of short-term capital. The major portion of working capital loans are provided by commercial banks. They provide a wide variety of loans tailored to meet the specific requirements of a concern.

The different forms in which the banks normally provide loans and advances are as follows:

• Loans
• Cash Credits
• Overdrafts
• Purchasing and discounting of
• Loans:

When a bank makes an advance in lump-sum against some security it is called a loan. In case of a loan,  a specified amount is  sanctioned by the bank to the

customer. The entire loan amount is paid to the borrower either in cash or by credit to his account. The borrower is required to pay interest on the entire amount of the loan from the date of the sanction.

A loan may be repayable in lump sum or installments. Interest on loans is calculated at quarterly rests and where repayments are stipulated in installments, the interest is calculated at quarterly rests on the reduced balances. Commercial banks generally provide short-term loans up to one year for meeting working capital requirements. But now-a-days term loans exceeding one year are also provided by banks. The term loans may be either medium-term or long- term loans.

• Cash Credits:

A cash credit is an arrangement by which a bank allows his customer to borrow money up to a certain limit against some tangible securities or guarantees. The customer can withdraw from his cash credit limit according to his needs and he can also deposit any surplus amount with him.

The interest in case of cash credit is charged on the daily balance and not on the entire amount of the account. For these reasons, it is the most favourite mode of borrowing by industrial and commercial concerns. The Reserve Bank of India issued a directive to all scheduled commercial banks on 28th March 1970, prescribing a commitment charge which banks should levy on the unutilized portion of the credit limits.

• Overdrafts:

Overdraft means an agreement with a bank by which a current account-holder is allowed to withdraw more than the balance to his credit up to a certain limit. There are no restrictions for operation of overdraft limits. The interest is charged on daily overdrawn balances. The main difference between cash credit and overdraft is that overdraft is allowed for a short period and is a temporary accommodation whereas

the cash credit is allowed for a longer period. Overdraft accounts can either be clean overdrafts, partly secured or fully secured.

• Purchasing and Discounting of Bills:

Purchasing and discounting of bills is the most important form in which a bank lends without any collateral security. Present day commerce is built upon credit. The seller draws a bill of exchange on the buyer of goods on credit. Such a bill may be either a clean bill or a documentary bill which is accompanied by documents of title to goods such as a railway receipt.

The bank purchases the bills payable on demand and credits the customer’s account with the amount of bill less discount. At the maturity of the bills, bank presents the bill to its acceptor for payment. In case the bill discounted is dishonoured by non-payment, the bank recovers the full amount of the bill from the customer along with expenses in that connection. In addition to the above mentioned forms of direct finance, commercial banks help their customers in obtaining credit from their suppliers through the letter of credit arrangement.

Letter of Credit:

A letter of credit popularly known as L/c is an undertaking by a bank to honour the obligations of its customer up to a specified amount, should the customer fail to do so. It helps its customers to obtain credit from suppliers because it ensures that there is no risk of non-payment. L/c is simply a guarantee by the bank to the suppliers that their bills up to a specified amount would be honoured. In case the customer fails to pay the amount, on the due date, to its suppliers, the bank assumes the liability of its customer for the purchases made under the letter of credit arrangement.