Financial management - UNIT 2

Prepared by
Dr.S. SHEIK FAREETH
Assistant Professor
Business Administration
Arul Anandar College
(Autonomous)
Karumathur

 The need forfunds:
No businesscan livewithout funds. Throughout the
life of a business, money is neededcontinuously.
Firms raise money mainly to meet thefollowing
three types of need:
1. Tostarta business as initial expenditure
2. Tofund continuous business activities andmoney
flowing
3. Toexpand the business.

Sources of funds
In general, a business may have two major sources of
funds which are needed for its business operations.
Theyare internal sourcesof fundsand external sources
of funds.

Sources of Funds
Internal Sources External Sources
Profit Depreciation Sales of assets
Long-term:
Share Capital
Loan Capital
Short term:
Overdraft
Leasing
Credit card…

Internal Sources of Funds
 Profit
The after-tax profit earned and retained by a
business which is an important and inexpensive
source of finance, for example, the retained
earnings of the business. A large part of financeis
funded from profit.

 Depreciation - The financial provision for the
replacement of worn-out machinery andequipment.
Nearly all businesses use depreciation as a source of
funds.
 Salesof Assets- The activity thata businesssellsoff
assets toraise funds forthe business.

External Long-term Sources of
Funds
 Sharecapital:
The most importantsourceof funds fora limited
company. It is often considered as permanentcapital
as it is not repaid by the business, but the shareholder
can havea share in the profit, called dividend.
Three types of sharesare:
1. Ordinaryshares: The mostcommon typesof shares,
and the most riskiestshares since noguaranteed
dividend. Dividend depends on how much profitis
made by the firm. Butall ordinary shareholders have
voting rights.

2. Preference shares: The share owners receive a fixed
rate of return. They carry less risk because
shareholders are entitled to the dividend before the
ordinary shares. But they are not strictly owners of the
company.
3.Deferred shares: These shares are often held by the
founders of the company. Deferred shareholders only
receive the dividend after the ordinary shareholders
have been paid.

 Loan capital
 Definition:
Any moneywhich is borrowed fora long period of
time bya business is called loan capital.
 Types:
There are four major types of loan capital:
Debentures, Mortgage, Loan specialists’
funds, Government assistance.

Types of loancapital:
1.Debentures: The holder of a debenture is a
creditor of the company, not an owner. Holders are
paid with an agreed fixed rate of return, but having no
voting rights. Theamountof money borrowed must be
repaid by the expirydate.
2.Mortgage: These are long-term bank loans
(usually over one year period) from banks or other
financial institutions. The borrower’s land orproperty
must be used as a securityon such as a loan.

3. Loan specialists’ funds: Theseare
venturecapitalistsor specialists who provide funds for
small businesses, especially for high techinvestment
projects in theirstart-upstage. Therearealso individuals
who invest in such businesses, which areoften called
‘businessangels’.
4.Government assistance: To
encourage small businesses and high employment,
governments may be involved in providing finance for
businesses. In the USA, there is an organization which
is called the Small Business Administration(SBA).

External Short-term Sources of
Funds
 Definition:
Short term sources of funds are usually the funds which
are less than one year for maturity. They are less stable
sources of funds forbusinesses.
 Types:
The main typesof external short term sources of funds
include:
1. Bank overdraft
2. Bank loan
3. Leasing
4. Creditcard
5. Tradecredit

Eternal short-term sources of loans
Major types Main characteristics
Bank
overdraft
This is a short term financing from banks.
The amount to be overdrawn depends on the needs of the business at
the time and its credit standing.
Interest is calculated from the time the account is overdrawn..
Bank loan This is a loan which requires a rigid agreement between the borrower
and the bank. The amount borrowed must be repaid over a certain
period or in regular installments.
Sometimes, banks change persistent overdrafts into loans, so
borrowers must repay at regular intervals.
Leasing Leasing allows businesses to buy plant, machinery or equipment
without paying large sums of money immediately.
The leasing company or bank hires or buys the equipment and for the
use of the hire company for a certain period of time. If the user can
never owns the equipment, it is an operating lease, while if it is given the
choice to own the equipment at the expiry time, it is a finance lease.
Lease payments are made by the hire company yearly or monthly, etc.

External short-term sources of loans(continued)
Major types Main characteristics
Credit card  Credit cards can be used to pay for hotel bills,
meals, shopping and materials, etc. They are
convenient, and secure because it can avoid the use
of cash and the payment of interests within credit
periods.
Cards may not be suitable for certain purchases,
especially a large sum of order because they have a
credit limit.
Trade credit  It is a common method for businesses to buy
materials and to pay for them at a later date, usually
between 30 and 90 days. Such trade credit given by
the seller is usually an interest free way of short

Sources of Funds
 Debt capital—funds obtained throughborrowing.
 Equitycapital—funds provided by the firm’s owners when
they reinvest earnings, make additional contributions, or
issue stock toinvestors.
 IPO- Initial publicoffer
 FPO
 American depository share(ADS)-US Dollar denominated
form of equity ownership in non UScompany.
 ADR-( American depository receipts)-Evidence forADS

Security
A security, in a financial context, is a certificate or
other financial instrument that has monetary value
and can be traded. Securities are generally classified
as either equity securities, such as stocksand
debt securities, such as bonds anddebentures.

Contd..
Securities are generally categorizedinto;
debt securities (e.g., banknotes, bonds anddebentures
equity securities (e.g., commonstocks)
derivatives (e.g., forwards, futures, options and swaps).

Debt securities
Debt security refers to a debt instrument, suchas
a government bond, corporate bond,certificate of deposit
(CD), municipal bond or preferred stock, that can be
bought or sold between two parties and has basic terms
defined, such as notional amount (amount borrowed),
interest rate, and maturity and renewal date. It also
includes collateralized securities, such as collateralized
debt obligations (CDOs), collateralized mortgage
obligations (CMOs), mortgage-backed securities issued by
the Government National Mortgage Association (GNMAs)
and zero-coupon securities.

Equity securities
Equity securities usually provide steady income as
dividends but may fluctuate significantly in their
market value with the ups and downs in the economic
cycle and the fortunes of the issuingfirm.
2.Right to subscribe for, or convert anothersecurity
(such as a bond) into, the common stock (ordinary
shares) of a firm.

Derivatives
a derivative is a contract that derives its value from the performance
of an underlying entity. This underlying entity can be an asset, index,
or interest rate, and is often simply called the "underlying.[ Derivatives
can be used for a number of purposes, including insuring against price
movements (hedging), increasing exposure to price movements for
speculation or getting access to otherwise hard-to-trade assets or
markets.Some of the more commonderivatives
include forwards, futures, options, swaps, and variations of these such
as synthetic collateralized debt obligations and credit default swaps.
Most derivatives are traded over-the-counter (off-exchange) or on an
exchange such as the Bombay Stock Exchange, while most insurance
contracts have developed into a separate industry. Derivatives areone
of the three main categories of financial instruments, the other two
being stocks (i.e., equities or shares) and debt (i.e., bonds and
mortgages).

MEANING
A new company can raise funds only through
external sources such as share , debenture ,
loans etc.
But an existing or a going concern which
needs finance for its future growth and
expansion can also generate through its
internal sources . Such as retained earnings
or ploughing back of profits , capitalisation of
profits and depreciation.

PLOUGHING BACK OFPROFITS
× In this all the profits of the year are not distributed among the shareholders . Total
profit retained in the firm . The process of retaining profits year after year and
their utilisation in business known as self financing or inter financing .

NEED OF PLOUGHING BACKOF PROFITS
× For replacement of old asset which have been
obsolete .
× For expansion and growth .
× For making company self dependent .
× For redemption of loan and debenture .
× For satisfy the working capital needsof
company .

FACTORS AFFECTING
× Earning capacity
× Desire and type of shareholder
× Dividend policy
× Taxation policy
× Future financial requirement

MERITS
× Economic method
× Help to redeem liabilities
× Increase productivity
× Decrease the risk of failure
× Safety of investment
× Make company self dependent
× Flexible financial structure

LIMITATIONS
× Over capitalisation
× Creation on monopolies
× Depriving the freedom of the investor
× Misuse of the retained earning
× Manipulation in value of shares
× Evasion of tax
× Dissatisfaction among the shareholder

DEPRECIATION AS A SOURCE OF
FINANCE
× It means the gradual decrease in the valueof asset
due to wear and tear and passage of time .
× In reality depreciation is simply a book entry
having the effect of reducing the book value of the
asset and profits of same year for the same
amount .

FACTORS INFLUENCING
INTERNAL SOURCES OF
FINANCE

INTRODUCTION
One of the most important consideration for an
entrepreneur-company in implementing a new
project or undertaking expansion, diversification,
modernization and rehabilitation scheme is
ascertaining the cost of project and the means of
finance. There are several sources of finance/funds
available to any company. An effective appraisal
mechanism of various sources of funds available to a
company must be instituted in the company to
achieve its main objective.

Business enterprises need funds to meet their different types
of requirements. All the financial needs of a business may be
grouped into the following categories:
SOURCES OF
FINANCE
TYPE
INTERNAL EXTERNAL
TIME
LONG TERM SHORT TERM
MEDIUM
TERM

INTERNAL SOURCES OF FINANCE
The various sources of internal finance for the business
includes:
 Owner’s Investment
 Retained Earnings
 Sale of Stock
 Sale of FixedAssets
 Utilizing Working Capital More Effectively
 Debt Collection

RETAINED
PROFITS
 This is one of the most important internal sourcesof
business finance.
 It represents the profits generated from sales afterinterest
payments to lenders, taxes to the government and
payments to shareholders in the form of dividends.
 The remaining profit is then retained or put back into the
business and available for future spending by the
organization.

OWNER’S
INVESTMENT
 This source consists of money injected by the owners
themselves in their business.
 This is an internal source of finance that can be in the
form of start-up capital – used when the business is
setting up – or in the form of additional capital – possibly
used for business’s expansion.

SALE OF
STOCK
 Purchase and storage costs use revenue that could
otherwise be used to expand the business.
 However, when reducing inventories enterprises should
be careful to retain the capacity to meet future demand.

SALE OF FIXED
ASSETS
 Fixed assets are those that are not easily convertedto
cash.
 Typically, these assets include equipment, property and
factories. Because these assets take time to convert to
cash, they cannot be relied on for short-term access to
finance. If you have the time, however, you could, for
example sell off some equipment or even property to
invest in your business.
 This is particularly useful if your needs have outgrown
some of your fixed assets. For example, if you need to
purchase a new equipment.

UTILIZING WORKING
CAPITAL MORE
EFFECTIVELY
 Working capital is money tied up in the business and used
to finance its day to day needs, such as buying raw
materials.
 All businesses have a working capital cycle thatidentifies
how this money moves around the business.
 A possible source of finance is squeezing or reducingour
own working capital needs.
 Therefore the cash we need is more efficiently used.
 Eg: If we minimize our stock levels we reduce the amount
of money tied up in stock.

DEBT
COLLECTION
 A debtor is someone who owes a businessmoney.
 A business can raise finance by collecting themoney
owed to them (debts) from their debtors.
 Not all businesses have debtors i.e. those who deal onlyin
cash.

FACTORS INFLUENCING SOURCES OF
FINANCE
 Purpose - What the finance is to be usedfor?
 Time Period - How long the finance will be needed for?
 Amount - How much money the business needs?
 Ownership and Size of the business
 A business should match the source of finance to its
specific use – in practice this means that a business
should secure long-term sources of finance for longterm
uses or needs and short term finance for immediate
needs.
 The cost of the source

 The organization’s objectives.
 The flexibility and availability of the finance. For
example, how easy it is to switch from one form of
funding to another, or whether a particular form of
finance is available for a new business with no trading
record.
 The impact the new funding would have on the
organizations current financial structure. For example, its
balance sheet.
 The state of the external environment. For example the
economy and consumer trends.
 The type of business structure it is. For example a sole
trader or partnership can raise funds from the stock
market.

Specialized Financial
Institutions Operating in India

1. Industrial Finance Corporation of
India (IFCI):
It was established in July 1948 as a statutory corporation under the Industrial Finance
Corporation Act, 1948.
the primary objective of providing long-term and medium-term finance to large
industrial enterprises. Its objectives include assistance towards balanced regional
development, encouraging new entrepreneurs to enter into the priority sectors and
the development of management education in the country.
For ensuring greater flexibility to meet the needs of the changing financial system IFCI
now stands transformed to IFCI Ltd. with effect from 1 June 1993.

2. State Financial Corporations
(SFCs):
To provide financial assistance to proprietary and partnership firms as well as
companies most of the states of our country have set up SFCs under The State
Financial Corporations Act, 1951.
SFCs provide finance in the form of long-term loans or through subscription of
debentures, offer guarantee to loans raised from other sources and take up
underwriting of public issues of shares and debentures made by companies.
However, they cannot directly subscribe to the shares issued by the companies.

3. Industrial Credit and Investment
Corporation of India (ICICI):
This was established in 1955 as a public limited company under the Companies Act,
1956
For providing long-term loans to companies for a period up to 15 years and subscribe
to their shares and debentures for the ultimate purpose of creation, expansion and
modernisation of industrial enterprises exclusively in the private sector.
The proprietary and partnership firms were also entitled to secure loans from ICICI.
It has also encouraged the participation of foreign capital in the country.

4. Industrial Development Bank of
India (IDBI):
It was set up in 1964 as a subsidiary of Reserve Bank of India.
with an objective to coordinate the activities of other financial institutions including
commercial banks and for providing financial assistance to all types of industrial
enterprises without any restriction on the type of finance and the amount of funds.
It also discounts and rediscounts the commercial bills of exchange and undertakes
underwriting of the public issues. IDBI has transformed into IDBI Ltd. with effect from
1 October, 2004.

5. State Industrial Development
Corporations (SIDC):
Many state governments have set up State Industrial Development Corporations in
1960s and early 1970s for promotions and development of medium and large-scale
industries in their respective states.
Many state governments have set up State Industrial Development Corporations in
1960s and early 1970s for promotions and development of medium and large-scale
industries in their respective states.

6. Unit Trust of India (UTI):
It was set up in 1964, under the Unit Trust of India Act, 1963.
With an investment trust with capital of 5 crores subscribed by Reserve Bank of India,
LIC, State Bank of India and other financial institutions. The basic objective of UTI is to
mobilise the community’s savings and channelize them into productive ventures.
It has also been extending financial assistance to the companies by way of term loans,
bills rediscounting, equipment leasing and hire purchase financing.

7. Small Industries Development Bank
of India (SIDBI):
It was set up in 1990 for the promotion, financing and development of small-scale
industrial enterprises.
It is an apex institution of all the banks providing credit facility to small-scale industries
in our country and offers refinancing of bills, rediscounting of bills, and several other
support services to Small Scale Industries (SSI).

Financial management - UNIT 2

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