Sources of Finance
Finance is essential for a business’s operation, development and
expansion. Finance is the core limiting factor for most businesses and
therefore it is crucial for businesses to manage their financial resources
properly. Finance is available to a business from a variety of sources both
internal and external.It is also crucial for businesses to choose the most
appropriate source of finance for its several needs as different sources
have its own benefits and costs. Sources of financed can be classified
based on a number of factors. They can be classified as Internal and
External, Short-term and Long-term or Equity and Debt. It would be
uncomplicated to classify the sources as internal and external.
2.1 Internal sources of finance
Internal sources of finance are the funds readily available within the
organisation. Internal sources of finance consist of:
Sale of fixed assets
External sources of finance
Sources of finance that are not internal sources of finance are
external sources of finance. External sources of finance are from sources
that are outside the business. External sources of finance can either be:
Ownership capital or
Sources of Finance: Ownership Capital
Ownership capital is the capital owned by the shareholders of a company. A
company can raise substantial funds through an IPO (initial public offering).
These funds are usually used for large expenses, such as new product
development, expansion into a new market and setting up a new plant. The
various types of shares are:
Ordinary shares: These are also known as equity shares and give the
owner the right to share the company’s profits and vote at the firm’s general
Preference shares: The owners of these shares may be entitled to a fixed
dividend, but usually do not have the right to vote.
Companies that are already listed on a stock exchange can opt for a rights
issue, which seeks additional investment from existing shareholders. They
could also opt for deferred ordinary shares, wherein the issuing company is
not required to pay dividends until a specified date or before the profits
reach a certain level.
Unquoted companies (those not listed on stock exchanges) can also issue
and trade their shares in over-the-counter (OTC) markets.
Sources of Finance: Non-Ownership Capital
Non-ownership capital includes funds raised from lenders, such as banks
and creditors. Companies typically borrow a fixed amount from a bank, at a
predetermined interest rate and with a fixed repayment schedule. Certain
bank accounts offer overdraft facilities. This is used by companies to meet
their short-term fund requirements, as they usually come at a very high
Factoring enables a company to raise funds using its outstanding invoices.
The company typically receives about 85% of the value of the invoice from
the factor. This method is more appropriate for overcoming short-term
Hire purchase allows a company to use an asset without immediately
paying the complete purchasing price. Trade credit enables a company to
obtain products and services from another firm and pay the bill later.
Sources of Finance: Venture Capital
Firms in the early stages of development can opt for venture capital. This
option gives the financing company some ownership as well as influence
over the direction of the enterprise.
Sources of Finance: Duration
Depending on the date of maturity, sources of finance can be clubbed into
Long-term sources of finance: Long-term financing can be raised from the
Share capital or equity share
Debentures/Bonds of different types
Loans from financial institutions
Loan from state financial corporation
Loans from commercial banks
Venture capital funding
Medium-term sources of finance: Medium-term financing can be raised
from the following sources:
Public deposits/fixed deposits for duration of three years
State financial corporations
Lease financing / hire purchase financing
External commercial borrowings
Foreign currency bonds
Short term sources of finance: Short-term financing can be raised from the
Fixed deposits for a period of 1 year or less
Advances received from customers
Various short-term provisions
a debenture is a document that either creates a debt or acknowledges it.
In corporate finance, the term is used for a medium- to long-term
debt instrument used by large companies to borrow money. In some
countries the term is used interchangeably with bond, loan stock or note.
A debenture is thus like a certificate of loan or a loan bond evidencing the
fact that the company is liable to pay a specified amount with interest and
although the money raised by the debentures becomes a part of the
company's capital structure, it does not become share capital.. 
Debentures are generally freely transferable by the debenture holder.
Debenture holders have no rights to vote in the company's general
meetings of shareholders, but they may have separate meetings or votes
e.g. on changes to the rights attached to the debentures. The interest paid
to them is a charge against profit in the company's financial statements.
Whenever a company wants to borrow a large amount of fund for a long
but fixed period, it can borrow from the general public by issuing loan
certificates called Debentures. The total amount to be borrowed is divided
into units of fixed amount say of Rs.100 each. These units are called
Debentures. These are offered to the public to subscribe in the same
manner as is done in the case of shares. A debenture is issued under the
common seal of the company. It is a written acknowledgement of money
borrowed. It specifies the terms and conditions, such as rate of interest,
time repayment, security offered, etc.
Features of Debentures
Debenture is a type of debt instrument issued to anyone who lend
money to a company for a specified term and interest rate. In
general, debentures have the following important features:
1) Debenture holders are not the owners of the company. They
are considered the creditors of the corporation or in other words,
the company borrow money from them through issuing
2) No voting rights. The debenture-holder is not a shareholder
and cannot vote in the company's general meetings.
3) Fixed rate of interest. A debenture with a fixed charge has a
fixed rate of interest. It can be presented as "10% Debenture".
They are always unsecured and earns a fixed rate of interest but
has no share of the profit.
4) Compulsory payment of interest. The interest on debenture is
payable irrespective of whether there are profits made or not.
5) Redeemable and Irredeemable. A redeemable debenture is the
one which is to be repaid within a maturity period, while
Irredeemable or Non-redeemable debentures cannot be
redeemed in the life time of the company and only repayable
upon the liquidation of the corporation
The different types of debentures have been explained in brief as
follows: Registered Debentures: These are those debentures
which are registered in the register of the company. the
names, addresses and particulars of holdings of debenture
holders are entered in a register kept by the company.
Such debentures are treated as non-negotiable
instruments and interest on such debentures are payable
only to registered holders of debentures. Registered
debentures are also called as Debentures payable to
Bearer Debentures: These are those debentures which
are not registered in the register of the company. Bearer
debentures are like a bearer check. They are payable to
the bearer and are deemed to be negotiable instruments.
They are transferable by mere delivery. No formality of
executing a transfer deed is necessary. When bearer
documents are transferred, stamp duty need not be paid. A
person transferring a bearer debenture need not give any
notice to the company to this effect. The transferee who
acquires such a debenture in due course bonafide and for
available consideration gets good title not withstanding any
defect in the title of the transfer-or. Interest coupons are
attached to each debenture and are payable to bearer.
Secured Debentures: These are those debentures which
are secured against the assets of the company which
means if the company is closing down its business, the
assets will be sold and the debenture holders will be paid
their money. The charge or the mortgage may be fixed or
floating and they may be fixed mortgage debentures or
floating mortgage depending upon the nature of charge
under the category of secured debentures. In case of fixed
charge, the charge is created on a particular asset such as
plant, machinery etc. These assets can be utilized for
payment in case of default. In case of floating charge, the
charge is created on the general assets of the company.
The assets which are available with the company at
present as well as the assets in future are charged for the
purpose. A mortgage deed is executed by the company.
The deed includes the term of repayment, rate of interest,
nature and value of security, dates of payment of interest,
right of debenture holders in case of default in payment by
the company. The deed may give a right to the debenture
holder to nominate a director as one of the Board of
Directors. If the company fails to pay the principal amount
and the interest thereon, they have the right to recover the
same from the assets mortgaged.
Unsecured Debentures: These are those debentures
which are not secured against the assets of the company
which means when the company is closing down its
business, the assets will not be sold to pay off the
debenture holders. These debentures do not create any
charge on the assets of the company. There is no security
for repayment of principal amount and payment of
interest. The only security available to such debenture
holders is the general solvency of the company. Therefore
the position of these debenture holders at the times of
winding up of the company will be like that of unsecured
debentures. That is they are considered with the ordinary
creditors of the company.
Convertible Debentures: These are those debentures
which can be converted into equity shares. These
debentures have an option to convert them into equity or
preference shares at the stated rate of exchange after a
certain period. If the holders exercises the right of
conversion, they cease to be the lender to the company
and become the members. Thus convertible debentures
may be referred as debentures which are convertible into
shares at the option of the holders after a specified period.
The rate of exchange of debentures into shares is also
decided at the time of issue of debentures. Interest is paid
on such debentures till its conversion. Prior approval of the
shareholders is necessary for the issue of convertible
debentures. It also requires sanction of the Central
Non-Convertible Debentures: These are those
debentures which cannot be converted either into equity
shares or preference shares. They may be secured or
unsecured. Non-convertible debentures are normally
redeemed on maturity period which may be 10 or 20
Redeemable Debentures: These debentures are issued
by the company for a specific period only. On the expiry of
period, debenture capital is redeemed or paid back.
Generally the company creates a special reserve account
known as "Debenture Redemption Reserve Fund" for the
redemption of such debentures. The company makes the
payment of interest regularly. Under section 121 of the
Indian Companies Act, 1956, redeemed debentures can be
Irredeemable Debentures: These debentures are issued
for an indefinite period which are also known as perpetual
debentures. The debenture capital is repaid either at the
option of the company by giving prior notice to that effect
or at the winding up of the company. The interest is
regularly paid on these debentures. The principal amount
is repayable only at the time of winding up of the company.
however, the company may decide to repay the principal
amount during its lifetime.
1. Control of company is not surrendered to debenture holders
because they do not have any voting rights.
2. Trading on equity is possible as debenture holders get a lower
rate of return than the earnings of the company.
3. Interest on debenture is an allowable expenditure under
income tax act, hence incidence of tax on the company is
4. Debenture can be redeemed when company has surplus funds.
5 Debenture holders have no right either to vote or take part in the
management of the company.
Since debentures are ordinarily issued for a fixed period, the
company can make the best use of the money. It helps long term
7 Interest paid on debentures is treated as an expense and is charged
to the profits of the company. The company thus saves incometax.
Debentures are mostly secured. On winding up of the company,
they are repayable before any payment is made to the shareholders.
Interest on debentures is payable irrespective of profit or loss.
1. Cost of raising capital through debentures is high of high
2. Common people cannot buy debenture as they are of high
3. They are not meant for companies earning greater than the
rate of interest which they are paying on the debentures.
4 As the interest on debentures have to be paid every year whether
there are profits or not, it becomes burdensome in case the
company incurs losses.
Usually the debentures are secured. The company creates a charge
on its assets in favour of debentureholders. So a company which
does not own enough fixed assets cannot borrow money by issuing
debentures. Moreover, the assets of the company once mortgaged
cannot be used for further borrowing.
6. Debenture-finance enables a company to trade on equity. But too
much of such finance leaves little for shareholders, as most of the
profits may be required to pay interest on debentures. This brings
frustration in the minds of shareholders and the value of shares
may fall in the securities markets.
7. Burdensome in times of depression : During depression the profits
of the company decline. It may be difficult to pay interest on
debentures. As interest goes on accumulating, it may lead to the
closure of the company.