DR D DEEPA-FINANCIAL MANAGEMENT & SOURCES OF FINANCE.pptx

UNIT - 1
FINANCIAL MANAGEMENT &
SOURCES OF FINANCE

FINANCE
Concept of Finance:
Finance is the life blood of business. “without
adequate finance no business can survive and without
efficient financial management no business can
prosper and grow”.
Definition:
“Finance may be defined as the position of money at
the time it is wanted”.
- F.W.Paish
“Finance is defined as the management of money and
includes activities like investing, borrowing, lending,
budgeting, saving, and forecasting”.

CLASSIFICATION OF FINANCE
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1. Public Finance: Public finance deals with the requirements, receipts
and disbursements of funds in the government institutions like states,
local self-governments and central government.
2. Private Finance: Private finance is concerned with requirements,
receipts and disbursements of funds in case of an individual, a profit
seeking business organisation and a non-organisation. Thus, private
finance can be classified into:
i. Personal Finance: It deals with the analysis of principles and
practices involved in managing one’s own daily need of funds.
ii. Business Finance: The study of principles, practices, procedures and
problems concerning financial management of profit making
organisations engaged in the field of industry, trade and commerce is
undertaken under the discipline of business finance.
iii. Finance of Non-Profit Organisations: The finance of non-profit
organisation is concerned with the practices, procedures and problems
involved in financial management of charitable, religious, educational,
Social and the other similar organisations.

3.Institutional Finance: Financial institutions,
collect savings from individual savers and
accumulate sufficient amount for profitable
investment in business organisations. It is related
to capital formation and meets requirements of
the economy. Financial institutions such as
Banks, Insurance Companies, Finance
corporations, Unit trusts etc.
4.International Finance: International finance is a
monetary transaction that occurs between two or
more countries.

FINANCE FUNCTION
1. Helps Establish a Business: Without money, we cannot get
labor, land and so on with the finance function we can
determine what is required to start our business and plan for it
2. Helps Run a Business: To remain in business we must cater
for the day to day operating costs such as paying salaries,
buying stationery, raw material, the finance function ensures
we always have adequate funds to cater for this.
3. To Expand, Modernize, Diversify: A business needs to grow
otherwise it may become redundant in no time. With the
finance function, we can determine and acquire the funds
required to do so.
4. Purchase Assets: we need money to purchase assets. This can
be tangible assets like furniture, buildings or intangible like
trademarks, patents etc. to get this you need finances.

OBJECTIVES OF FINANCE FUNCTION
The objective of finance functions is to arrange as much
funds for the business as are required from time to time.
This function has the following objectives:
1. Proper utilisation of funds: In any concerns, funds do not remain idle
at any point of time. The funds committed to various operations should
be effectively utilized. Those projects should be preferred which are
beneficial to the business.
2. Increasing profitability: To increase profitability, sufficient funds will
have to be invested. Finance function should be planned that the
concern neither suffers from inadequacy of funds nor wastes more
funds than required. A proper control should be exercised so that
scarce resources are not frittered away on uneconomical operations.
3. Maximising value of firm: Finance function also aims at maximising
the value of the firm. It is generally said that a concern’s value is
linked with its profitability.

FINANCIAL MANAGEMENT
Meaning: ‘Financial’ means procuring sources of money
supply and allocation of these sources on the basis of
forecasting monetary requirements of the business. The
word ‘Management’ refers to planning, organisation, co-
ordination and control of human activities and physical
resources for achieving the objectives of an enterprise.
Definition:
“Financial management is concerned with the efficient use
of an important economic resources, namely, capital
funds”. – Soloman
“Financial management is the application the planning &
control functions of the finance functions”.
– Howard & Upton

SCOPE OF FINANCE FUNCTION/
Broadly, it has two approaches:
1. Traditional Approach – Procurement of Funds
2. Modern Approach – Effective Utilization of Funds
1.TRADITIONAL APPROACH: (Year - 1920)
• The scope of finance function was treated, in the narrow sense of procurement or
arrangement of funds.
• The finance manager was treated as just provider of funds, when organisation was
need of them.
• The utilisation or administering resources was considered outside the purview of the
finance function. It was felt that the finance manager had no role to play in
decision-making for it utilization.
As per this approach, the following aspects only were included in the scope
of financial management:
1.Estimation of requirements of finance
2.Arrangement of funds from financial institutions
3.Arrangement of funds through financial instruments such as shares, debentures, bonds
and loans
4.Looking after the accounting and legal work connected with the raising of funds.

Limitations of Traditional Approach:
1.Outsider-Looking –in approach: The approach equated finance function with the
raising and administrating of funds. i.e., Outsiders, bankers, investors etc.
2.Ignored routine problems: The approach gave undue emphasis to episodic or frequent
happenings in the life of an enterprise.
3.Ignored non-corporate enterprises: The approach focused attention only on the
financial problems of the enterprises. Non-corporate industrial organisations
remained outside its scope
4.Ignored working capital financing: The approach laid overemphasis on the problems
of corporate enterprises.
5.No emphasis on allocation of funds: The approach confined financial management to
issues involving procurement of funds. The following central issues of financial
management:
i. Should an enterprise commit capital funds to certain purposes?
ii. Do the expected returns meet financial standards of performance?
iii. How should these standards be set and what is the cost of capital funds to the
enterprise?
iv. How does the cost vary with the mixture of financing methods used?

2.MODERN APPROACH:
• The term financial management in a broad sense and provides a conceptual and analytical
framework for decision-making.
• According to it, the finance function covers both acquisitions of funds as well as their
allocation.
The financial management, in the modern sense of the term, can be broken down
into three major decisions as functions of finance. They are:
1.Investment Decision:
• Investment decisions relate to selection of assets in which funds are to be invested by the
firm.
• Investment decisions relate to the total amount of assets to be held and their composition in
the form of fixed and current assets. Both the factors influence the risk the organisation is
exposed to. The most important factor is how the investors perceive the risk.
The investment decisions results in purchase of assets. Assets can be classified, two
broad categories:
i). Long-term investment decisions: The long term capital decisions are referred to as capital
budgeting decisions, which relate to fixed assets. The fixed assets are long-term, in nature.
ii). Short-term investment decisions: It is also referred to as working capital management.
The finance manager has to allocate among cash and cash equivalents, receivables and
inventories. It is necessary for proper, efficient and optimum utilization of fixed assets.

2.Finance Decision:
• The next step of modern approach is how to raise finance for the concerned investment.
• Finance decision is concerned with the mix or composition of the sources of raising the funds
required by the firm.
• In finance decision, the finance manager is required to determine the proportion of equity and
debt which is known as capital structure.
• There are two main sources of funds, shareholders’ funds and borrowed funds. Borrowed
funds are not permanent sources to the firm. On the other hand, the shareholders funds are
permanent sources to the firm.
3.Liquidity Decision:
• Liquidity decision is concerned with the management of current assets.
• Working capital management is concerned with the management of
current assets.
• It is concerned with short-term survival. Short term-survival is a
prerequisite for long term survival.
4.Dividend Decision:
• The term ‘dividend’ related to the portion of the profit, which is distributed
to shareholders of the company.
• Dividend decision is concerned with the amount of profits to be distributed and
retained in the firm.
• The dividend decision depends on the preference of the equity shareholders and investments

FUNCTION OF FINANCIAL MANAGEMENT
1.INVESTMENT DECISION:
The investment decision relates to the selection of assets in which funds
will be invested by a firm. The assets which can be acquired fall into
two broad groups:
i. Long-term assets or fixed assets which are used for earning over a
longer period.
ii. Short-term or current assets which can be converted into cash
within an accounting period.
The mutual ratio between fixed and current assets affects the quantum of
risk of the firm. This risk affects the cost of different sources of finance.
Thus, investment decisions are mainly of two types:
i. Capital budgeting decisions: Under this decisions, financial
manager has to decide as to which of the different available
alternatives the best to invest in.
ii. Working capital decisions: In this decisions, financial manager
must maintain adequate balance in liquidity and profitability.

2.FINANCING DECISION:
The investment decision is broadly concerned with the asset-mix or the
composition of the assets of a firm. The concern of the financing decision is
with the financing-mix or capital structure or leverage.
3.DIVIDEND POLICY DECISIONS:
The dividend decision relating to the dividend policy. The dividend
decision should be analysed in relation to the financing decision of a firm.
Two alternatives are available in dealing with the profits of a firm. One is
distributed to the shareholders and another one is retaining the dividend.
4.LIQUIDITY DECISION:
It is concerned with the management of current assets. Basically this is
working capital management; it is concerned with the management of
current assets.
5.DIVIDEND DECISION:
Dividend decision is concerned with the amount of profit to be distributed
and retained in the firm. The term dividend relates to the portion of the
profit, which is distributed to shareholders of the company.
FUNCTION OF FINANCIAL MANAGEMENT

IMPORTANCE OF FINANCIAL MANAGMENT
1. Financial planning and control: Finance is the base for all business
activities. Business activities should be not only harmonized but also
planning determination and implementation offer analysis of financial
activities revolve around the finance.
2. Essence of managerial decision: Financial management provides a sound
base to all managerial decisions.
3. Financial management is a scientific & Analytical analysis: In this
process of decision making and financial analysis modern mathematics
techniques are used.
4. Continuous administration function: in older times financial management
was used periodically and its importance was limited to the procurement of
funds but in modern times finance is a continuous administrative function.
5. Centralized nature: Functional areas such as marketing & production are
decentralised in the modern industrial concern, but financial co-ordination
and control and achieved through centralised.
6. Basis of managerial process: Financial management is the basis of whole
management process, such as planning, co-ordination and control.

IMPORTANCE OF FINANCIAL MANAGEMENT
1.Financial planning and control
2.Essence of managerial decision
3.Financial management is a scientific and
analytical analysis
4.Continuous administration function
5.Centralized nature
6.Basis of a managerial process
7.Measure of performance

OBJECTIVES OF FINANCIAL MANAGEMENT
Goals/Objectives of
Financial Management Profit Maximization Wealth Maximisation

Profit Maximization
Profit: Profit is the making of gain in business activity for the
benefit of the owners of the business.
Profit = Total Cost – Total Revenue
Thus, profit maximization is considered as the main objective of
business.
Features of profit maximisation:
1. Profit maximisation is also called as cashing per share
maximisation.
2. Ultimate aim of the business concern is earning profit; hence, it
considers all the possible ways to increase the profitability of the
concerns
3. Profit is the parameter of measuring the efficiency of the
business concern.
4. Profit maximisation objectives help to reduce the risk of the
business.

Profit Maximization
Arguments in favour of profit maximisation:
1. Profit is the test of economic efficiency
2. Efficient allocation of fund
3. Social welfare
4. Internal resources for expansion
5. Reduction in risk and uncertainty
6. More competitive
7. Desire for controls
8. Basis of Decision-making
Limitation of profit Maximisation:
9. Quality of benefits
10. Ambiguity-Vague(uncertain nature)
11. Timing and value of money-ignored
12. Changed in organisation structure
13. Social welfare may be ignored
14. Ignores financing and dividend aspects

WEALTH MAXIMISATION
Wealth maximization is considered
as the appropriate objective of an enterprise.
When the firms maximizes the stakeholder‘s
wealth, the individual stakeholder can use this
wealth to maximize his individual utility.

Arguments in favor of wealth maximization:
• (i) Due to wealth maximization, the short term
money lenders get their payments in time.
• (ii) The long time lenders too get a fixed rate
of interest on their investments.
• (iii) The employee share in the wealth gets
increased.
• (iv) The various resources are put to
economical and efficient use.

Arguments against wealth maximization
• (i) It is socially undesirable
• (ii) It is not a descriptive idea
• (iii) Only stock holders wealth maximization is
endangered when ownership and
management are separate

PROFIT MAXIMISATION VS WEALTH MAXIMISATION
BASIS FOR COMPARISON
Concept
Emphasizes on
Consideration of Risks
and Uncertainty
Advantage
Recognition of Time
Pattern of Returns
PROFIT MAXIMIZATION
The main objective of
a concern is to earn a
larger amount of profit.
Achieving short
term objectives.
No
Acts as a yardstick for
computing the operational
efficiency of the entity.
No
WEALTH MAXIMIZATION
The ultimate goal of the
concern is to improve the
market value of its shares.
Achieving long term objectives.
Yes
Gaining a large market share.
Yes

FINANCIAL MANAGEMENT RELATIONSHIP WITH OTHER FUNCTIONAL AREAS
The relationship between financial management and other
functional areas can be defined as follows:
• 1. Financial Management and Production
Department: The financial management and the
production department are interrelated. The production
department of any firm is concerned with the production
cycle, skilled and unskilled labour, storage of finished
goods, capacity utilisation, etc. and the cost of production
assumes a substantial portion of the total cost.
• The production department has to take various decisions
like replacing machinery, installation of safety devices,
etc. and all the decisions have financial implications.

FINANCIAL MANAGEMENT RELATIONSHIP WITH OTHER
FUNCTIONAL AREAS
• 2. Financial Management and Material
Department: The financial management and the material
department are also interrelated. Material department
covers the areas such as storage, maintenance and supply
of materials and stores, procurement etc.
• The finance manager and material manager in a firm may
come together while determining Economic Order
Quantity, safety level, storing place requirement, stores
personnel requirement, etc. The costs of all these aspects
are to be evaluated so the finance manager may come
forward to help the material manager.

FINANCIAL MANAGEMENT RELATIONSHIP WITH OTHER FUNCTIONAL AREAS
3. Financial Management and Personnel Department: The personnel
department is entrusted with the responsibility of recruitment, training and
placement of the staff. This department is also concerned with the welfare
of the employees and their families. This department works with finance
manager to evaluate employees’ welfare, revision of their pay scale,
incentive schemes, etc.
4. Financial Management and Marketing Department: The marketing
department is concerned with the selling of goods and services to the
customers. It is entrusted with framing marketing, selling, advertising and
other related policies to achieve the sales target. It is also required to frame
policies to maintain and increase the market share, to create a brand name
etc. For all this finance is required, so the finance manager has to play an
active role for interacting with the marketing department.

• What is finance?
Money used to purchase things the business
needs or want.
• What is a source of finance?
It is a method of getting hold of the
money you need. Most of the time you have
to pay it back and it can be expensive.
When does a business need
finance?

How many source of finance do you know?
• Source of finance Short Term
(Based on the Time Medium Term
Duration) Long Term

Sources of finance
Types of Finance Period of repayment Purpose
Short Term Less than a year
Purchase of raw materials,
payment of wages, rent,
insurance etc.
Medium Term 1 year to 5 years
Expenditure on
modernization, renovation,
heavy advertising etc.
Long Term More than a 5 years
Purchase of land and
building, plant and
machinery etc.

Sources of finance
Internal sources:
Finance from within
the business.
External sources:
Finance from outside the
business.

Short term sources of finance
Meaning of short term of finance:
Arranging of available external funds to meet the needs of a firm for a year or less
time.
After establishment of a business, funds are required to meet its day to day
expenses. Short term loans help business concerns to meet their temporary
requirements of money.
1.Indigenous(Native or Local) Bankers:
Indigenous bankers are private firms or individuals who operate as
banks and as such both receive deposits and give loans. Like banks,
they are also financial intermediaries.
They should be distinguished professional moneylenders whose
primary business is not banking but money lending.
After nationalisation of commercial banks and the spread of banking in
urban and rural areas, the activities of indigenous bankers have declined,
but their importance has not become less because of the difficulties still
faced by the borrowers in getting loans from the banks.

2. Instalment credit:
Instalment credit is a loan for a fixed amount of money. The
borrower agrees to make a set number of monthly payments
at a specific dollar amount. An instalment credit loan can
have a repayment period lasting from months to years until
the loan is paid off.
An instalment account is one that involves a regular
payment. These types of loans have a set start point and end
point.
Instalment credit is an important aspect of your credit score
because it shows that you can maintain a payment over time.
Examples: car loans, mortgages, and student loans

Advantages of Instalment Credit
• Convenient – Using credit while travelling or shopping can be more
convenient than carrying cash. It also provides an itemized list of your
monthly expenditures. Credit cards are often readily accepted. They may
also earn you benefits in their rewards program.
• Allows use of other people’s money – during the time you purchase
something and when you pay it off, you are using someone else’s money.
• Immediate – unexpected costs like a car repair can be met quickly.
• Can buy a large purchase you do not have cash for such as a car, house,
etc.
• Can enjoy using something while paying for it.
• At times you may be able to take advantage of sales which you do not
have cash for at the time.
• An advantage of using credit is that it establishes a credit history.
• Credit cards make is possible to order merchandise via the internet.

Disadvantages of Instalment Credit:
• In most cases credit usually costs money, in the form of
interest or other fees. This adds to the total cost of the item.
• It can be tempting to overspend. Instead of comparison
shopping for the best price, you save time and purchase it now.
• Overuse of credit can lead to a poor credit record.
• Buying on credit can be habit forming.

3.Advances: Some business houses get advances from their
customers and agents orders and this source is a short-term
source of finance of them. It is a cheap source of finance
and in order to minimise their investment.
Advantages:
1. Interest free
2. No tangible security
3. No repayment obligation
Disadvantages:
1.Limited amount
2.Limited period
3.Penalty in case of non-delivery of goods

4.Accrued expenses and Deferred Income:
An accrued expense is an accounting expense recognized in
the books before it is paid for. Accrued expenses are typically
periodic, and are documented on a company's balance sheet
as current liabilities. Accrued expenses are also known
as accrued liabilities.
Deferred revenue or deferred income(unearned income) is
the payment of goods and services that the Company has
received from its customers even before such goods and
services have delivered or performed. Such a payment has
been received by the Company but not yet earned.

5.Account payable/Creditors: Accounts payable (AP) is money
owed by a business to its suppliers shown as a liability on a
company's balance sheet. Vouchered, or vouched, means that
an invoice is approved for payment and has been recorded in
the General Ledger or AP sub ledger as an outstanding, or
open, liability because it has not been paid.
6.Trade credit: For many businesses, trade credit is an essential
tool for financing growth. Trade credit is the credit extended to
you by suppliers who let you buy now and pay later. Any time
you take delivery of materials, equipment or other valuables
without paying cash on the spot, you're using trade credit.

Advantages of Trade Credit
• Increased sales
• Customer loyalty
• Competitive advantage
Disadvantages of Trade Credit:
• Negative effect on cash flow
• Must investigate creditworthiness of customers
• Monitoring accounts receivable
• Financing accounts receivable
• Possibility of bad debts

7.Bills discounting: An accepted draft or bill of exchange sold
for early payment to a bank or credit institution at less than
face value after the bank deducts fees and applicable interest
charges. The bank or credit institution then collects full value
on the draft or bill of exchange when payment comes due.

8.Factoring: Factoring is a financial service in which the
business entity sells its bill receivables to a third party at a
discount in order to raise funds.
It differs from invoice discounting. Concept of invoice
discounting involves, getting the invoice discounted at a
certain rate to get the funds, whereas the concept of
factoring is broader.
Factoring involves the selling of all the accounts receivable
to an outside agency. Such an agency is called a factor.

• FUNCTIONS OF FACTOR
The factor performs the following functions:
• Maintenance of sales ledger: A factor is responsible for
maintaining the sales ledger of the client. So the factor takes care
of all the sales transactions of the client.
• Financing: The factor finances the client by purchasing all the
account receivables.
• Credit protection: In the case of non-resource factoring, the risk
of non-payment or bad debts is on the factor.
• Collection of money: The factor performs the duty of collecting
funds from the client’s debtors. This enables the client to focus on
core areas of business instead of putting energies in the collection
of money.

• ADVANTAGES OF FACTORING
The following are the advantages:
• It reduces the credit risk of the seller.
• The working capital cycle runs smoothly as the factor immediately
provides funds on the invoice.
• Sales ledger maintenance by the factor leads to a reduction of cost.
• Improves liquidity and cash flow in the organization.
• It leads to improvement of cash in hand. This helps the business to
pay its creditors in a timely manner which helps in negotiating better
discount terms.
• It reduces the need for the introduction of new capital in the business.
• There is a saving of administration or collection cost.

• DISADVANTAGES OF FACTORING
The following are the disadvantages:
• Factor collecting the money on behalf of the company can lead
to stress in the company and the client relationships.
• The cost of factoring is very high.
• Bad behaviour of factor with the debtors can hamper
the goodwill the company.
• Factors often avoid taking responsibility for risky debtors. So
the burden of managing such debtor is always in the company.
• The company needs to show all details about company
customers and sales to factor.

Long term sources of finance
EQUITY
SHARES
DEBT/
DEBENTURES
PREFERRED
STOCK/
PREFERENCE
SHARES
RETAINED
EARNING
LOANS FROM
FINANCIAL
INSTITUTIONS

1.Equity capital: The Equity Capital refers to that portion
of the organization’s capital, which is raised in exchange
for the share of ownership in the company. These shares
are called the equity shares.
The equity shareholders are the owners of the company
who have significant control over its management. They
enjoy the rewards and bear the risk of ownership.
However, their liability is limited to the amount of their
capital contributions.
The Equity Capital is also called as the share capital or
equity financing.

Equity shares have the following features:
(i) Equity share capital remains permanently with
the company. It is returned only when the
company is wound up.
(ii) Equity shareholders have voting rights and
elect the management of the company.
(iii) The rate of dividend on equity capital
depends upon the availability of surplus funds.
There is no fixed rate of dividend on equity
capital.

Advantages of Equity Capital:
It has several advantages:
• The firm has no obligation to redeem the equity shares since
these have no maturity date.
• The equity capital act as a cushion for the lenders, as with
more and more equity base, the company can easily raise
additional funds on favorable terms. Thus, it increases the
creditworthiness of the company.
• The firm is not bound to pay dividends, in case there is a
cash deficit. The firm can skip the equity dividends without
any legal consequences.

Disadvantages of Equity Capital:
There are several disadvantages of raising the finances through the issue
of equity shares which are listed below:
• With the more issue of equity shares, the ownership gets diluted along
with the control over the management of the company.
• The cost of equity capital is high since the equity shareholders expect a
higher rate of return as compared to other investors.
• The cost of issuing equity shares is usually costlier than the issue of
other types of securities. Such as underwriting commission, brokerage
cost, etc. are high for the equity shares.
• The cost of equity is relatively more, since the dividends are paid out of
profit after tax, but the interest payments are tax-deductible.
Note: Number of equity shares to be issued to the shareholders is based
on the regulations laid down in the Companies Act and SEBI guidelines.

2. Debt/Debentures: A certificate or voucher acknowledging a
debt. Or the ability of a customer to obtain goods or services
before payment, based on the trust that payment will be made
in the future.
Features of debentures:
1. Fixed interest rate: Debenture holders are the creditors of
the company. They are entitled to periodic payment of
interest at a fixed rate.
2. Maturity: Debentures are repayable after a fixed period of a
time, say 5 years or 7 years as per agreed terms.
3. No voting rights: They do not carry voting rights.
4. Secured assets: debentures are secured.

• Types of Debentures
Debentures on the basis of Registration
1. Registered Debentures: The debentures which are payable to the
registered debenture holders are called registered debentures. These
debentures are not transferable by mere delivery. The names of the
holders of these debentures with details of the number, value and type of
debenture held are recorded in the register of debenture holders.
Registered debentures are not negotiable instruments. Transfer of such
debentures requires registration.
2. Bearer Debentures: Bearer debentures are those which are payable to the
bearer. These debentures are transferable by mere delivery. The register
of debenture holders does not have the names of the debenture holder
recorded. Hence they are transferable by mere delivery. Registration of
transfer is not necessary. Bearer debentures are also called as
Unregistered Debentures.

Debentures on the basis of Security
1. Secured Debentures: The debentures, which are secured fully or
partly by a charge over the assets of the company are called secured
debentures. The charge may be either a fixed charge or a floating
charge. The charge, when created should be registered with the
Registrar within 30 days of its creation.
2. Unsecured Debentures: The debentures, which are not secured
fully or partly by a charge over the assets of the company are called
unsecured debentures. They are also called Naked Debentures. They
are not mortgaged. The general solvency of the company is the only
security for the holders. The debenture holders are treated as only
unsecured creditors. Issue of such debentures are not much popular.

Debentures on the basis of Redemption
1. Redeemable Debentures: The debentures, which are repayable after a
certain period as per the terms of their issue, are called redeemable
debentures. Sometimes, they can be redeemed by the company on
demand by the holders or at the discretion of the company.
2. Irredeemable Debentures: They are perpetual debentures. The
debentures, which are not repayable during the life time of the
company, are called irredeemable debentures. The company has no
obligation to make the payment of the principal of these debentures
during its life time. The company may repay the money at the time of
liquidation or on the happening of a contingency or on the expiration
of a longer period or when the company breaches the terms of issue of
the debentures.

Debentures on the basis of Conversion
1. Convertible Debentures: The debentures, which are convertible
into equity shares or preference shares the option of the holders, after a
certain period, are called convertible debentures.
2. Non-Convertible Debentures: The debentures, which are not
convertible into equity shares, are called non-convertible debentures.
Debentures on the basis of Priority
1. Preferred Debentures: The debentures, which are paid first at the time
of winding up, are called preferred debentures or first debentures. Thus
they are just like preference shares.
2. Ordinary Debentures: Debentures, that are paid after the preferred
debentures during the winding up of a company are called ordinary
debentures.

• Debentures on the basis of Status
1. Equitable Debentures: Debentures, that are secured
by deposit of title deeds of the property with a
Memorandum creating a charge, are called equitable
debentures. In this case, the property is with the
company.
2. Legal Debentures: The debentures, which are
secured by actual transfer of the legal ownership of
the property from the company to the holder, are
called legal debentures.

Advantages of debentures:
The following are the advantages of debentures:
1. Secured investments: Debentures provide greatest security to the investors. They make
a very good appeal to the conservative minds.
2. Fixed return: Debentures guarantee a fixed rate of interest.
3. Stable prices: Their prices are more stable as compared to shares because the changing
monetary conditions affect the price movement of the debentures very little.
4. Non-interference in management: The debenture holders do not interfere in the
management of the company.
5. Economical: It is a cheaper method of raising finance. Lower rate of interest further
makes them more economical.
6. Availability of funds: The companies can raise money through debentures easily
compared to equity and preference shares.
7. Regular source of income: The investors get fixed and regular interest, whether the
company earns profit or not.

Disadvantages of debentures:
The following are the limitations of Debentures.
1. Permanent burden of interest: Interest on debentures is always cumulative.
It is to be paid irrespective of the profits or otherwise of the company. During
the period of depression, it becomes a heavy burden.
2. Limits company’s credit: Since in most of the cases, the assets of the
company are mortgaged with the debenture holders as a security against their
advances, the credit worthiness of the company falls in the eyes of the public
as well as the banks. Borrowings from other sources becomes difficult.
3. No right to participate in company management: Ordinarily debenture
holder do not enjoy any voting rights in the companies. They have no interest
in the election of directors. They do not have representation in the
management of the affairs of the companies.

3. Preference shares: Preference shares are those shares which
carry certain special or priority rights. Firstly, dividend at a fixed
rate is payable on these shares before any dividend is paid on
equity shares.
Secondly, at the time of winding up of the company, capital is
repaid to preference shareholders prior to the return of equity
capital.
Preference shares do not carry voting rights.
However, holders of preference shares may claim voting rights if
the dividends are not paid for two years or more on cumulative
preference shares and three years or more on non-cumulative
preference shares.

Advantages:
1. Appeal to Cautious Investors: Preference shares can be easily sold to investors who prefer
reasonable safety of their capital and want a regular and fixed return on it.
2. No Obligation for Dividends: A company is not bound to pay dividend on preference
shares if its profits in a particular year are insufficient. It can postpone the dividend in case
of cumulative preference shares also. No fixed burden is created on its finances.
3. No Interference: Generally, preference shares do not carry voting rights. Therefore, a
company can raise capital without dilution of control. Equity shareholders retain exclusive
control over the company.
4. Trading on Equity: The rate of dividend on preference shares is fixed. Therefore, with the
rise in its earnings, the company can provide the benefits of trading on equity to the equity
shareholders.
5. No Charge on Assets: Preference shares do not create any mortgage or charge on the assets
of the company. The company can keep its fixed assets free for raising loans in future.
6. Flexibility: A company can issue redeemable preference shares for a fixed period. The
capital can be repaid when it is no longer required in business. There is no danger of over-
capitalisation and the capital structure remains elastic.

Disadvantages:
1. Fixed Obligation: Dividend on preference shares has to be paid at a fixed rate and before
any dividend is paid on equity shares. The burden is greater in case of cumulative
preference shares on which accumulated arrears of dividend have to be paid.
2. Limited Appeal: Bold investors do not like preference shares. Cautious and conservative
investors prefer debentures and government securities. In order to attract sufficient
investors, a company may have to offer a higher rate of dividend on preference shares.
3. Low Return: When the earnings of the company are high, fixed dividend on preference
shares becomes unattractive. Preference shareholders generally do not have the right to
participate in the prosperity of the company.
4. No Voting Rights: Preference shares generally do not carry voting rights. As a result,
preference shareholders are helpless and have no say in the management and control of
the company.
5. Fear of Redemption: The holders of redeemable preference shares might have
contributed finance when the company was badly in need of funds. But the company may
refund their money whenever the money market is favourable. Despite the fact that they
stood by the company in its hour of need, they are shown the door unceremoniously.

• Types of preference shares:
(i) Cumulative preference shares: A preference share is said to be cumulative when the
arrears of dividend are cumulative and such arrears are paid before paying any
dividend to equity shareholders.
(ii) Non-cumulative preference shares: In the case of non-cumulative preference shares,
the dividend is only payable out of the net profits of each year. If there are no profits in
any year, the arrears of dividend cannot be claimed in the subsequent years. If the
dividend on the preference shares is not paid by the company during a particular year,
it lapses. Preference shares are presumed to be cumulative unless expressly described
as non-cumulative.
(iii) Participating preference shares: Participating preference shares are those shares
which are entitled in addition to preference dividend at a fixed rate, to participate in
the balance of profits with equity shareholders after they get a fixed rate of dividend
on their shares. The participating preference shares may also have the right to share in
the surplus assets of the company on its winding up. Such a right may be expressly
provided in the memorandum or articles of association of the company.
(iv) Non-participating preference shares: Non- participating preference shares are
entitled only to a fixed rate of dividend and do not share in the surplus profits. The
preference shares are presumed to be non-participating, unless expressly provided in
the memorandum or the articles or the terms of issue.

(v) Convertible preference shares: Convertible preference shares are
those shares which can be converted into equity shares within a
certain period.
(vi) Non-Convertible preference shares: These are those shares which
do not carry the right of conversion into equity shares.
(vii) Redeemable preference shares: A company limited by shares,
may if so authorized by its articles issue preference shares which are
redeemable as per the provisions laid down in Section 80. Shares
may be redeemed either after a fixed period or earlier at the option of
the company.
(viii) Guaranteed preference shares: These shares carry the right of a
fixed dividend even if the company makes no or insufficient profits.

4. Retained earnings: Like an individual, companies too, set aside a part of their
profit to meet future requirements. The portion of profits not distributed among the
shareholders but retained and used in business is called retained earnings. It is also
referred to as ploughing back of profit. This is one of the important sources of
internal financing used for fixed as well as working capital. Retained earnings
increase the value of shareholders in case of a growing firm.
• Features of Retained Earnings:
The important features of retained earnings as a source of internal financing
have been summarized below:
1. Cost of Financing: It is the general belief that retained earnings have no cost to the
company.
2. Floatation Cost: Unlike other sources of financing, the use of retained earnings
helps avoid issue- related costs.
3. Control: Use of retained earnings avoids the possibility of change/dilution of the
control of existing shareholders that results from issue of new issues.
4. Legal Formalities: Use of retained earnings does not require compliance of any
legal formalities. It just requires a resolution to be passed in the annual general
meeting of the company.

Advantages of Retained Earnings:
• The advantages or benefits of retained earnings may be stated as
under:
i. Cheaper Source of Financing: The use of retained earnings does not
involve any acquisition cost. The company has no obligation to pay
anything in respect of retained earnings.
ii. Financial Stability: Retained earnings strengthen the financial position of
a business and thereby give financial stability to the business.
iii. Stable Dividend: Shareholders may get stable dividend even if the
company does not earn enough profit.
iv. Market Value: Retained earnings strengthen the financial position of a
company and appreciate the capital which ultimately increases the
market value of shares.

Disadvantages of Retained Earnings:
• Retained earnings are the result of conservative dividend policy
of the company and are associated with following demerits:
i. Improper Utilization of Funds: If the purpose for utilization of
retained earnings is not clearly stated, it may lead to careless
spending of funds.
ii. Over-capitalization: Conservative dividend policy leads to huge
accumulation of retained earnings leading to over-capitalization.
iii. Lower Rate of Dividend: Retained earnings do not allow
shareholders to enjoy full benefit of the actual earnings of the
company. This creates not only dissatisfaction among the
shareholders but also adversely affect the market value of shares.

5. Loans from financial institutions: A financial
institution (FI) is a company engaged in the business of
dealing with financial and monetary transactions, such
as deposits, loans, investments and currency exchange.
Financial institutions encompass a broad range of
business operations within the financial services sector,
including banks, trust companies, insurance
companies, brokerage firms and investment dealers.

Advantages of Financial institutions:
The Advantages of raising funds through financial institutions are as follows:
(i) Financial institutions provide long-term finance, which are not provided
by commercial banks;
(ii) Besides providing funds, many of these institutions provide financial,
managerial and technical advice and consultancy to business firms;
(iii) Obtaining loan from financial institutions increases the goodwill of the
borrowing company in the capital market. Consequently, such a company
can raise funds easily from other sources as well;
(iv) As repayment of loan can be made in easy instalments, it does not
prove to be much of a burden on the business;
(v) The funds are made available even during periods of depression, when
other sources of finance are not available.

Disadvantages
• The major Disadvantages of raising funds from financial institutions are
as given below:
(i) Financial institutions follow rigid criteria for grant of loans. Too many
formalities make the procedure time consuming and expensive;
(ii) Certain restrictions such as restriction on dividend payment are
imposed on the powers of the borrowing company by the financial
institutions;
(iii) Financial institutions may have their nominees on the Board of
Directors of the borrowing company thereby restricting the powers of
the company.
(iv) Many deserving concerns may fail to get assistance for want of security
and other conditions laid down by these institutions.

DR D DEEPA-FINANCIAL MANAGEMENT & SOURCES OF FINANCE.pptx

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