Chapter 3 – Source of Finance

Chapter 3

Source of finance explains how a business firm finds fund to meet its financial necessities. In three different ways a business firm finds its finance. They are given below.

I. LONG TERM FINANCE

These are the financial necessities of the firm which require finance for more than five years. Long term finance is invested in fixed assets so liquidity is either nil or very less. A company obtains long term finance through share capital, debt capital and its own undistributed profit.

A) Share Capital

A share is a fractional part of the capital of the company which forms the basis of ownership in the company.

Characteristics of Share:

  1. Company gets fixed and long term finance by the issue of shares.
  2. Share is transferable, so a share holder can sell it to anybody.
  3. Share holders have the right to get dividend from the profits of the company.
  4. Share holders are the owners of the company, so they can control the management of the company.
  5. Liability of the share holders is limited up to the value of shares subscribed by them.

Type of Shares:

a) Equity Share or Common stock:

It is the ordinary share, which contributes to the capital of a company. Equity share holders are the real owners of the company and they can participate in the management of the company.

Features:

Fixed Capital: it gives fixed capital to the company.

No fixed dividend: higher dividend, when there is more profit and no dividend when there is loss.

Voting right: equity share holders elect the management of the company by voting in general meeting.

Transferable: equity shares can be sold at any time to others.

Not returned: equity shares cannot be returned during the life time of the company.

Paid last: equity shares are paid last, if the company stops its business.

b) Preference Share:

Shares which have preferential rights as to payment of dividend and return of capital over the equity shares are called Preference shares.

Features:

Fixed Capital: it gives fixed capital to the company.

Fixed Dividend: dividend is paid every year at a fixed rate to the preference share holders.

No Voting right: they have no voting right to elect the management of the company.

Transferable: Preference share can also sold any time to others.

Return of capital: preference shares are returned before paying equity shares, when company stops business.

Type of Preference Shares:

  1. Cumulative Preference shares: Preference shares for which a company fails to pay dividend in a particular year, it will carry forward to next year.
  2. Participating Preference shares: If there is more profit, these types of shares can participate in the profit of the company over and above their fixed rate of dividend.
  3. Convertible Preference shares: Preference shares which can be converted into equity shares are called convertible preference shares.
  4. Redeemable Preference shares: These types of shares can be paid back to the holders during life time of the company.

B) DEBT CAPITAL

Capital provided by the Creditorsis called Debt Capital. The forms of receiving debts capital are debentures, bonds and term loans.

i)Debenture:

It is a long term loan under which a letter of acceptance of a debt is issued by the company under its common seal and which specifies the amount of loan, rate of interest and other conditions.

Features:

Long term capital: debentures are used as a long term capital. It is repaid after a long period.

Creditor: Debenture holders are the creditors and not owners of the company.

Freely transferable: debentures can be transacted freely in the market.

No voting right: since debenture holders are creditors they have no voting right.

Repayment: Debentures are repaid before any shares are repaid in case of liquidation.

Fixed rate of interest: Debenture holders are paid interest at fixed rate every year.

ii) Bond:

Bonds are long term loan which are issued by the company by mortgaging the assets of the company and are termed as secured or guaranteed debentures.

Both Debenture and Bond are long term loans issued by the company. The only difference is the Bond is secured by the company’s assets but the debenture is not secured by any assets.

Bond Indenture

Bond indenture is the agreement (contract) between the issuer (company) and the bondholder that will protect the interest of the investor.

Classification of Bonds

  • Fixed interest Bonds,
  • Participating and Profit sharing Bonds,
  • Bearer Bonds,
  • Registered Bonds,
  • Mortgage Bonds,
  • Convertible Bonds, etc,.

iii) Term Loan:

These are long term loans provided by the specified financial institutions and can be repaid after 7 years. These loans are secured by the assets purchased by using such loans. Companies use these loans to purchase fixed assets.

II. MEDIUM –TERM FINANCE

The medium term finance or debts are repayable between three to seven years. These loans are mainly used as working capital but sometimes it uses for purchasing fixed assets.

Sources of Medium term finance: companies can arrange medium term loans by the following ways:

  1. Public deposits: companies accept deposits from public at a certain rate of interest.
  2. Issue of redeemable preference shares: companies issue redeemable preference shares for short period.
  3. Issue of redeemable debentures.
  4. Bank Loan
  5. Loan from Specific Financial Institutions.

III. SHORT TERM FINANCE

Finance arranged for one year or less is called short term finance. These are more concerned with the management of working capital and these are used for current assets and meeting daily expenditure.

Sources of Short term finance:

1. Bank source: commercial bank like Bank Muscat, Bank Dhofar, Oman International Bank etc., provides short term loans to the industries by way of

  1. Overdraft: it is a facility under which Banks allow the depositors to withdraw more than their deposits up to a fixed limit. Interest is to be paid on the amount actually received.
  2. Cash Credit: This is an arrangement wherein bank fixes a maximum loan limit for the customers. The customer can get loans within the fixed limit whenever he is in need. Bank charges interest on that amount only which the customer takes as loan and interest is not charged on the entire limit.
  3. Secured Loan: These are the loans granted by the bank under the guarantee of current assets.
  4. Discounting of bills of exchange:

2. Non-Bank Source: Like Trade Credit, Leasing and finance companies, Public deposits etc.,

EXCERCISE

I. Fill in the blanks.

  1. ______Share capital gives ownership to its holders.
  2. An individual who holds shares is called ______.
  3. An individual who holds Debenture is called ______.
  4. Mainly there are ______types of shares.
  5. ______, ______, ______, and ______are the different types of preference shares.
  6. A share is a ______of share capital.
  7. ______type of shares have no maturity period.
  8. On the basis of period (term) source of capital is divided into ______, ______and ______finance.
  9. ______Preference shares can be converted into equity shares.
  10. Mr. Ahammed has RO.10,000 with him, he wants to invest his amount in a company and he needs security and regular income for his investment, then which type of security will you recommend? ______
  11. ______Share holders get dividend in the subsequent years if they are not paid dividend in any year.
  12. The capital of big companies which issue shares is normally called ______capital.
  13. ______share holders get fixed rate of dividend
  14. Dividend is a part of ______.
  15. Mr.Hilal invested his RO.5000 in equity shares of a company. During 2007 the company suffered a loss. How much amount does he gets as dividend? ______
  16. ______, ______and ______are the different forms of Debt capital.
  17. Debenture which has security is ______
  18. An individual who holds Bonds is called ______holder.
  19. Term loan is normally given by ______to the companies.
  20. Term loans get security of ______.
  21. Companies give ______(benefit) to the Debt capital.
  22. The function of finding finance for the company to meet its requirement is called ______
  23. Companies invest long term finance in ______.
  24. Liquidity of the long term finance is ______.
  25. Undistributed profit is a type of ______finance.
  26. Share capital forms the basis of ______.
  27. An Indenture specifies ______. (write at least three points)
  28. Companies return back the amount of shares to the share holders ______(True / False).
  29. ______share holders elect (choose) the management of the company.
  30. Liability of the share holders is ______.
  31. The real owners of a company are ______.
  32. ______Share holders have no voting right.
  33. ______Shares are transferable.
  34. A company can return back the amount of equity shares to the share holders at the time of ______.
  35. If a company stops its business, then ______will get their amount last.
  36. Preference shares have preference over ______with regard to ______and ______.
  37. Bonds are also called ______debentures.
  38. The only difference between Bond and Debenture is ______.
  39. The agreement between a company and bond holder is called ______.
  40. A Bond which can be transferred by mere delivery is called ______Bond.
  41. A bond which gets additional profit over and above the interest is called ______Bond.
  42. Bond Indenture is an ______.
  1. A term finance which is repaid within 3 to 7 years is called ______finance.
  2. Debentures can be issued to arrange ______finance or ______finance.
  3. Fixed asset can be purchased by using ______finance.
  4. ______and ______are two sources of Medium-term finance.
  5. For working capital requirement, companies usually take ______finance.
  6. Bank Loan is a type of ______finance.
  7. All the equity share holders participate in the management of the company (True / False) ______.
  8. A share holder can sell his share to any person. ______(True / False)

II. Answer the following Questions:

51. Write any four differences between Equity share and Preference share.

Equity share / Preference share

52. Write any four differences between Share capital and Debt capital.

Share capital / Debt capital

53. Write any four common features of Equity share and Preference share.

Equity share / Preference share

University of Nizwa / CEMIS / Department .of Management Studies / BUSINESS FINANCE / Dr.Ayoob / Page

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