Financial Management

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UNIT 1
Financial Management

Nature of Scope of Financial Management

During the past three decades role and responsibilities of finance manager have undergone a marked
transformation ever witnessed earlier. The finance manager has now become an integral part of the
business enterprise and is involved in all the activities that take place in the enterprise. Until recently,
finance executive was considered as keeper of books of accounts and provider of funds needed by the
firm. But today his responsibility is not limited ot procurement of funds but extends beyond it to ensure is
optimal utilization. He plays pivotal role in planning quantum and pattern of fund requirements, procuring
the desired amount of funds. Since all the business activities like marketing, purchase and production
involve cash planning and utilization or generation of funds, the finance manager must take cognizance of
his involvement in all the activities of the firm. He must also have clear conception of the overall objective
of his firm as he has to act in conformity lea with the objective. Furthermore, he has to evaluate the
effectiveness of financial decisions in the light of some standard objectives of the firm.
OBJECTIVE OF THE FIRM
Objectives are long-term purpose and mission, which state the reason for existence of the firm and declare
what it wants to achieve in the long run. They represent desired results, the firm wishes to attain by its
existence arid operations. They indicate specific sphere of aims, activities and accomplishment.
Being profit seeking organization, the management is supposed to set profit maximization as the objectives
and accomplishment.
PROFIT MAXIMIZATION OBJECTIVES
Profitability objective may be stated in terms of profits, return on investment, or profit-to sales ratios.
According to this objectives, all such actions as increase income and cut down costs should be undertaken
and those that are likely to have adverse impact on profitability of the enterprise should be avoided.
Advocates of the profit maximization objective are of the view that this objectives is simple and has the
inbuilt advantage of judging economic performance of the enterprise. Further, it will direct the resources in
those channels that promise maximum return. Since the finance manager is responsible for the efficient
utilization of capital, it is plausible to pursue profitability maximization as the operational standard to test
the effectiveness of financial decisions.
However, profit maximization objective suffers from several drawbacks, rendering it as an ineffective
decisional criterion. These drawbacks are:

(1) It is vague
Ambiguity of the term profit as used in the profit maximization objective is its first weakness.
It is not clear in what sense the term profit has been used. It may be total profit before tax or after tax or
profitability rate. Rate of profitability may again be in relation to share capital, owners funds, total capital
employed or sales. Which of these variants of profit maximization objective to be considered remains
vague? Furthermore, the word profit does not speak anything about short-term and long-term profit. A firm
can maximize its short-term profit by avoiding current expenditures on maintenance of a machine. But
owing to this neglect, the machine being put to use may no longer be capable of operating after some time
with the result that the firm will have to defray huge investment outlay to replace the machine. Thus, profit

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maximization suffers in the long run for the sake of maximizing short-term profit. Obviously, long-term
consideration of profit cannot be neglected in favour of short-term profit.

(2) It ignores times value factor

Profit maximization objective fails to provide any idea regarding timing of expected cash earnings. For
instance, it there are two investment projects and suppose one is likely to produce streams of earnings of
Rs. 90,000 in sixth year from not and the other is likely to produce annual benefits of Rs. 15,000 in each of
he ensuring six years both the projects cannot be treated as equally useful ones although total benefits of
both the projects are identical because of differences in value of benefits received today and those
received a year or two years after. Choice of more worthy projects lies in the study of time value of future
inflows of cash earnings. The interest of the firm and its owners is affected by the time value factor. Profit
maximization objective does not take cognizance of this vital factor and treats all benefits, irrespective of
the timing, as equally valuable.
(3) It ignores risk factor
Another serious shortcoming of the profit maximization objective is that it overbooks risk factor. Future
earnings of different projects are related with risks of varying degrees. Hence, different projects may have
different values even though their earnings capacity is the same. A project with fluctuating earnings is
considered more riskier thatn the one with certainty of earnings. Naturally in investor would provide less
value to the former than to the latter. Risk element of project is also dependent on the financing mix of the
project. Project largely financed by way of debt is generally more riskier than the one predominantly
financed by means of share capital.It view of the above, the profit maximization objective is inappropriate
and unsuitable as an operational objective of the firm. Suitable and operationally feasible objective of the
firm should be precise and clear cut and should give weightage to time value and risk factors. All these
factors are well taken care of by wealth maximization objective, which we shall discuss, in the following
paragraphs.
WEALTH MAXIMIZATION OBJECTIVE
Wealth maximization objective is a widely recognized criterion with which the performance of a business
enterprise is evaluated. The word wealth refers to the net present worth of the firm. Therefore, wealth
maximization is also stated as net present worth. Net present worth is the difference between gross
present worth and amount of Capital investment required to achieve the benefits. Gross present worth
represents the presents value of expected cash benefits discounted at a rate which their certainly or
uncertainly. Thus, wealth maximization objective as decisional criterion suggests that any financial action
which creates wealth or which has a net present value above zero is desirable one and should be accepted
and that which does not satisfy this test should be rejected.
Algebraically, net present value or worth can be expressed as follows, using Ezra Solomons symbols and
models

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Where W = net present worth

A1, A2 ..... An = the stream of benefits expected to occur from a course of action over a period of time.
K = appropriate discount rate to measure risk and timing
C = initial outlay required to acquire the asset
The objective of wealth maximization as pointed out above has the advantage of exactness and
unambiguity and takes care of time value and risk factors.
The wealth maximization objective when used as decisional criterion serves as a very useful guideline in
taking investment decision. This is because the concept of wealth is very clear. It represents present value
of the benefits minus the cost of the investment. The concept of cash flow is more precise in connotation
than that of accounting profit. Thus, measuring benefits in terms of cash flows generated avoids ambiguity.
The wealth maximization objective considers time value of money. It recognizes that cash benefits
emerging from a project in different years are not identical in value. this is why annual cash benefits of a
project are discounted at a discount rate to calculate total value of these cash benefits. At the same time, it
also gives due weightage to risk factor by making necessary adjustments in the discount rate. Thus, cash
benefits of a project with higher risk exposure is discounted at higher discount rate (cot of capital), while
lower discount rate is applied to discount expected cash benefits of a less risky project. In this way,
discount expected cash benefits of a less risky project. In this way, discount rate used to determine present
value of future streams of cash earnings reflects both the time and risk.
In view of the above reasons, wealth maximization objective is considered superior to profit maximization
objective. It may be noted here that value maximization objective is simply the extension of profit
maximization to real life situations. Where the time period is short and magnitude of uncertainly is not gear,
value maximization and profit maximization amount to almost the same thing.

GOAL OF FINANCIAL MANAGEMENT

Goals of financial management should be so articulated as to help achieve the objective of wealth
maximization. Financial goals may be stated as maximizing long-term as well as short-term profits and
minimizing risks. These goals imply that the finance manager should take financial decisions in such way
as to ensure high level of profits. He should also seek courses of action that avoid unnecessary risks and
anticipate problem areas and ways of overcoming difficulties.
In the pursuit of the above goals, finance manager should recognize the interrelationship between profit
and risk. In fact, value of a firm is influenced jointly by return and risk. In real world, the relationship
between the two is inverse. Investments promising high profits will be more riskier than their counterparts.
It is, therefore, the prime responsibility of the finance manager to strike judicious balance between return
and risk in order to maximize value of the firm. To assure maximum profits to the firm, the finance manager
must monitor the cash inflows and outflows of the business and thereby ensure effective utilization of
resources. He should also endeavour to build in sufficient flexibility in the financial operations of the
enterprise so as to deal with uncertainty. He has to gain flexibility by identifying strategic alternatives both
in regard to investment outlets and acquisition of funds.
Another major financial goal of a firm is imparting sufficient liquidity and profitability of the enterprise. Thus,
a finance manger while managing funds has to ensure that the firm has adequate liquid resources on hand
to satisfy its obligation at all times and in addition it has a certain level above its expected needs to act as a

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reserve to meet emergencies. But if the firm carries large amount of funds in cash, it losses opportunity
cost of the funds and therefore, goal of high level of profit suffers. A firm to improve its return must ensure
optimum utilization of resources. Thus, the finance manager is in dilemma. The dilemma is high profitability
means low liquidity and, vice-versa. He must, therefore, strike satisfactory trade off between profitability
and liquidity.

MANAGEMENT vs OWNERS
The management of an enterprise is supposed to pursue the objective set for the firm. Although they may
not act in the best interests of the owners and pursue its goal to fulfill their ambitions of perpetuating their
control over the enterprise, the possibility of pursuing its personal goals exclusively is remote and limited
because of the constant evaluation of the managerial performance in the light of the overall goal. The
management acting against this goal will not be allowed to continue. Furthermore, in a competitive world, a
company must undertake actions which are reasonably consistent with wealth maximization goal.
However, on certain occasions the interest of the management may clash with that of the owners. Thus, an
entrenched management plays the role of a satisficer rather than of a maximiser. The term satisficer here
means a person willing to settle for something less. An entrenched management desirous of perpetuating
its existence for years to come may like to play safe and seek in acceptable level of growth rather than take
the risks to maximize the wealth of stockholders.
It is cumbersome task to determine when a particular management is playing the role of a satisficer and
when it is acting as maximiser. For instance, when a risky venture is rejected because its potential benefits
fall short of its potential costs, how it can be ascertained that decision to reject the venture was motivated
by satisficing factor.
In sum, it can be observed that the management may have other goals but the goal of maximising owners
interest is the dominant goal which the management has to persue because more and more firms now-adays are tying their compensation to the firms performance. Even the existence of the management is
linked to the maximization goal.

SOCIAL OBJECTIVE
The modern firm has another objectives to assume social responsibility. Being a socio-economic organ, a
business enterprise has a responsibility towards various sections of the society. This is necessary not only
because society provides environment conductive to the operation of business enterprise put also for their
survival. No organization can exist any longer without its social acceptance.
A socially responsible enterprise has to conduct its business in a manner that earns recognition as a
constructive and honourable corporate citizen in its relation, designed to be mutually profitable with
stockholder, employees, customers, suppliers, community and government.
It is usually contended that pursuit of social objective interferes with the economic objectives of an
enterprise because social activities will raise costs and risks. Assumption of social obligations by business
is ; therefore ; likely to weaken its economic vitality of the firm and pose threat to its existence.
The above line of argument emerges from those who ardently believe that economic objects and social
objectives are militant to each other. Social obligations increase cost of operations and therefore,
profitability of the enterprise may be adversely affected in the short run but in the long run economic
objectives and social responsibility of business are compatible to each other ; in fact, they reinforce each
other. As economic organs of society, business enterprises are socially responsible to pursue their profit

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making objectives to the optimum extent by meeting the material needs of society. In fact, the major social
responsibility of a company is to operate profitability and utilize efficiently the resources at its disposal.
Society does not gain but loss if business performance suffers.
A business enterprise can serve society only when it operates successfully. Profit is essential to the
survival of a firm and also to the support of all non-economic activities. Unless a business is able to make a
profit, the question of coping with social responsibilities voluntarily is largely academic. Economic
objectives are, in fact, means to the social ends of welfare and public interest.
There would not be any reason to suppose that a socially responsible business will earn less, pay fewer
dividends and achieve appreciation of share price than the one who are only as responsible as the law
requires. Social activities of a firm may arise cost of business immediately but in the long run it will be
counter balanced by the increased earnings resulting from its social action. Thus, if management decides
to pay higher wages to workers, ensures job security and improves working conditions, cost of operations
may go up immediately but increased productivity due to highly motivated workers will reduce per unit cost
of operations. In the same view, a firm can raise funds from investors at cheaper rate if it has been able to
ensure fair rate of dividends of its owners. Supply of quality goods at reasonable price will help the firm in
augmenting its sales and improving its earnings because of customers satisfaction.
Even contribution by business organizations to general welfare programmes have several economic spinoffs to business. For example, charitable contributions to social causes tend to enhance the image of the
business enterprise in public mind and are likely to improve its market standing.
Thus, in the long run profit objectives and social objectives do not conflict. Much depends on top
management personal values, social concern and capability. Management with high social sensitiveness
and strong feeling of personal obligation, considerable drive and skill can turn social ills into a business
opportunity.

EVOLUTION OF BUSINESS FINANCE

To have a clear understanding of the role and responsibilities of finance manager, it would be worthwhile to
study changing contents of business finance as an academic discipline.
Before the turn of the present century finance was studied as a part of economics. Study of finance as a
separate discipline began only in the early part of the present century when massive consolidation
movement took place. Formation of large sized undertakings by consolidating the smaller ones brought
before the management the problem of financing these gaint enterprises. Accordingly, overwhelming
emphasis was placed to the study of sources and forms of financing the new industrial giants. Authorities
on finance, like Meade, Dewing and Lyon dealt with, in a scholarly fashion, the problems of capitalisation,
choice of capital structure, promotions, sale of securities, nature and terms of financial contracts and
similar other matters related to source of raising of funds. Thus, the study of business finance remained
descriptive one.
Emphasis on study of potentially of different securities as a source of procuring funds from outside world
and the role and functions of institutional agencies including investment bankers continue to exist during
1929s since this decade witnessed a burst of new industries, like radio, chemical, steel and automobile
upon the economic scene of the USA, the emergence of national advertising and improved distribution
practices and the euphoria of high profit margins.
1930s was a period of grave economic recession which created formidable problem of liquidity.
Businessmen found it difficult ot acquire funds from banks and other institutions to meet their day-to-day
requirements. They had to liquidate their inventory holdings to meet their financial needs. But owing to

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precipitate fall in price level the inventory liquidation did not provide sufficient funds to meet the
requirements. The impact of these developments upon financial management was manifested by improved
methods of planning and control, great concern for liquidity and greater interest in sound financial structure
of the firm. Writers on business finance opined vehemently that finance manager would have to play
defensive role to protect the firm from dangers of bankruptcy and liquidation. Thus, as in the past during
this decade too literature on business finance placed considerable emphasis on major financial episodes in
the life cycle of he firm.
Problem of financing assumed new dimension in the post world war II, Reorganization of industries to cope
with the peace time requirements of the economy posed serious problem before the business community
to raise substantially large amount of capital form the market. Accordingly, in 40s financial experts
continued to be concerned with the necessity for selecting financial structures that would be able to
withstand the stresses and strains of he post war adjustments.
Thus, the approach to business finance, popularly known as traditional approach, which was evolved in the
beginning of the present century and which analysis the firm from an outsiders points of view instead of
emphasizing the decision making aspects within the firm, remained popular until the early 50s.
In the early 50s the U.S. economy witnessed vigorous spurt of the business activity on the one hand and
despondent stock market and tightening money market conditions, on the other. In view of this, emphasis
shifted from profitability analysis to cash flow generation with a resultant deemphasis of the previously
favoured financial ratio analysis. The finance manager was assigned the responsibility of managing the
cash flows in such a manner that the organisation will have the means to carry out its objectives as
satisfactory as possible and at the same time its obligations as they become due. There was thus observed
a market shift away from the institutional and external financing aspects to the primary emphasis on day-today financial operations of the firm. Cash budget technique occupied a place of pride in writing on business
finance. Matters like cash budget forecasting, aging receivables, analysis of purchases and application of
inventory controls received greater emphasis.
The change in approach to business finance noticed in the early 50s was reaffirmed in the subsequent
years. Limited range of profit opportunities for mature industries and relatively tight money market
conditions which were the characteristic features of these years impelled the necessity for allocation of
capital resources to most profitable investment outlets. Accordingly, capital budgeting as a tool of efficient
allocation of funds within the firm received dramatic premiums. The finance manager had to assume the
new responsibility of managing the total funds committed to total assets and allocating funds to individual
assets in consonance with the overall objectives of the business enterprise.
Consequent upon a series of heated debates regarding cost of capital, optimal capital structure and effects
of capital structure upon the cost of capital and the market value of the firm that the profession went
through, a number of sophisticated valuation models were introduced and advanced techniques like
portfolio selection, mathematical programming and simulations were developed which improved the
practice of financial management.
The period between the mid 1960s and the early 1970s was marked as a very fruitful and exciting era for
a number of interesting developments. The brief but ominous recession in the share market spurred a large
number of diverstitures, reorganizations and bankruptcies and renewed concern for liquidity and profit
margins. The analytical and empirical frontiers of the discipline were also at the same time redefined and
redesigned. The Finance manager started rethinking such important issues as aggregate stock prices, the
empirical efficiency of business sales, the profitability of institutional investors and the analytical efficiencies
of various portfolio selection criteria on a new line.

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Thus, the dimension of business finance which was earlier limited to periodic or episodic financial events
has in recent years broadened to include the study of day-to-day operations of the financial management
alongside the periodic financial events. The case study is not being increasingly used as an aid in learning
how to analyze and solve typical and recurring problems of financial management. The interest in case
study this stemmed from a desire for a more analytical approach.

MEANING OF BUSINESS FINANCE

Literally speaking, the term business finance contents finances of business activities. Thus, to develop the
meaning of business finance appreciation of the meaning of business and finance is necessary.
In common paralance the word Business is used to denote merchandising, the operation of some sort of a
shop or store, a large or small. It is, however, giving too narrow a meaning to the word. Business must be
understood to embrace every human activity (usually activated by the hope of profits, whereby mans
wants are supplied. Lumbering, merchandising and many other activities are business that helps to supply
material wants. The practices of law, medicine, dentistry, teaching, accounting, nursing, entertaining
represents a few of the types of business activities that supply desired services. Thus, business can be
categorized into three groups : Commerce, Industry and Service.
Commerce is concerned with the transfer of commodities through numerous channels from the producer to
the ultimate consumers. It includes collecting, grading, warehousing, transporting and insuring of
commodities. Industrial activity, on the other hand, is concerned with the sale of goods produced by
manufacturers. Thus, industrial businesses are those that actually produce commodities either by
manufacture or by some definite treatment of materials or that produce and supply the raw materials, which
may be used in their original form or form which marketable commodities can be manufactured. In addition,
there are certain business activities that do not deal in tangible commodities, instead they render services
for making profit. Such activates are classified under the category Services. Railroad and steam
companies, doctors, lawyers and bankers, brokers, accountants, teachers, actors, musicians and other
who do not deal with the commodities are the concrete example of services class of business activity.
Having explained the meaning of business we now proceed finance ahead to define the term. Finance,
refers to the application of skills or care in the manipulation, use and control of money. This is as far as the
dictionary goes. It would, however, not be in fitness of things to place too heavy reliance on the dictionary
meaning of finance because the word finance has a marvelous ability to evoke different concepts in the
minds of different persons. We have, therefore, to turn from dictionary to observe what is being
contemplated in actual world about finance.
The word finance in real world has been interpreted differently by different authorities. More significantly, as
noticed in the preceding paragraphs, the concept of finance has changed markedly with change in times
and circumstances. For the convenience of analysis, different viewpoints on finance have been categorized
into three major groups.
(i) The first category incorporates the views of all those who contend that finance concerns with
acquiring funds on reasonable terms and conditions to pay bill promptly. This approach covers
study of financial institutions and instruments from which funds can be secured, the types and
duration of obligations to be issued, the timing of the borrowings or sales of stocks, the amounts
required, urgency of the need and the cost. This approach has the virtue of shedding light on the
very heart of the finance function. However, the approach is too restrictive. It lays stress on only
one aspect of finance and ignores the other aspect which is very vital.

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(ii) The second approach holds that finance is concerned with cash. Since almost all business
transactions are expressed ultimately in terms of cash, every activity within the firm is the concern
of the finance manager. Thus, according to this approach finance manager is required to go into
details of every business activity be it concerned with purchasing, production, marketing, personnel
administration, research and other associated activities. Obviously, such a definition is too broad to
be meaningful.
(iii) A less third approach to finance looks on finance as being concerned with acquisitions of funds and
wise application of these funds. Protagonists of this approach opine that responsibility of a finance
manager is not only limited to procurement of adequate cash to meet business requirements but
extends beyond this to optimal utilization of funds. Since money involves cost, central task of the
finance manager, while allocating resources is to match the advantages of potential uses against
the costs of alternative sources so as to maximize the value of the firm. This is the managerial
approach which is also known as problem-centred approach, since it emphasizes that the finance
manager is his endeavour to maximize the value of the firm has to deal with vital problems of the
firm viz., what capital expenditure should the firm make? What volume of funds should the firm
invest? How should the desired funds be financed? How can the firm maximize its profitability from
existing and proposed commitments?
Diagrammatic of the management approach to finance give below will help appreciate the approach.

Fig. 1.1.
MANAGEMENT APPROACH TO FINANCE
Activities (Core Idea)
Funds Sources
I.

Funds Uses

Internal Cash Flows from operations

and special transactions.

I.

Asset Expenditures
A. Current
B. Fixed

II.

External Debts or equity funds

supplied by:

II. Non-asset expenditure

A. Labour

A. Individuals

B. Interest and debt service Charges

B. Financial Institutions
C. Other business firms
D. Government
III.

Distributions to owners and / or

losses

The management approach to finance is balanced one having given equal weightage to both procurement
and utilization aspects of finance and hence has received wider recognition in the modern world.

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Thus, business finance may be defined as the process of raising, providing and managing of all the money
to be used in connection with business activities. The similar view is also held by the modern scholars as
would be clear from perusal of some of the following definitions.
Business Finance can be broadly defined as the activity concerned with planning, raising, controlling and
administering of funds used in the business
Guthmann & Dougall
The finance function is the process of acquiring and utilizing funds by a business.
R. C. Osborn
Finance consists in the raising, providing, managing of all the money, capital, or funds of any kind to be
used in connection with the business.
Bonneville and Dewey
Business Finance deals primarily with raising, administrating and disbursing funds by privately owned
business units operating in nonfinancial fields of industry.
Prather and Wert

NATURE OF FINANCE
Financial management is an integral part of overall management and not a staff function. It is not only
confirmed to fund raising operations but extends beyond it to cover utilization of funds and monitoring its
uses. These functions influence the operations of other crucial functional areas of the firms such as
production, marketing and personnel. In view of this, overall survival of the firm is influenced by its financial
operations.
The heart of the financial management lies in decision making in the areas of investment, finance and
dividend. In investment decision a finance manager has to decide about total amount of assets to be held
in the enterprise and kinds of the assets the proportion of fixed assets and current assets. The basic
problems facing the finance manager concerning investments are:
(i)

How should the firm invest?

(ii)

In which specific projects should the firm invest?

In financing decision the finance manager has to decide as to how much funds the firm should raise to fund
its operations and in what form-debt, equity shares, preferences shares and after sources. While deciding
about the debt-equity mix the finance managers endeavour should be to evolve such a pattern as may be
helpful in maximizing earnings per share and also market value of the firm.
The finance manager while making dividend decision decides as to how the firms should be allocated
between dividend and retention. He has to formulate such a dividend policy as may provide sufficient funds
to finance the firms growth requirements and at the same time ensure reasonable dividends to the
stockholders.
The above decisions are intimately related. Thus, the proportion in which fixed assets and current assets
are mixed determines the risk complexion of the firm. Costs of various methods of financing are affected by
this risk. Likewise, dividend decisions influence financing decisions and themselves influenced by
investment decisions.

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10

Since finance functions are intimately connected with other business functions, the finance manager
should call upon the advise of other functional executives of the firm while making decisions particularly in
regard to investment. Decisions in regard to kinds of fixed assets to be acquired for the firm, level of
inventories to be kept in hand, type of customers to be granted credit facilities, terms of credit, etc., should
be made after consulting production and marketing executives. However, the determination of dividend
policies is almost exclusive finance functions and the finance manager need not consult other functional
mangers.
Finally, imperativeness, of the continuous review of the financial decisions explains generic nature of the
financial management. As a matter of fact, financial decision making is a c continuous dynamic process
that goes on throughout the corporate life. An enterprise to survive has constantly to interact with various
environmental forces and adapt and adjust alive to changes in internal as well as external environment and
bring about necessary adjustments in goals, strategies, policies and procedures with a view to seizing
potential opportunities and minimizing impending threats. A one time financial plan not subjected to
periodic review and modification in the light of changed conditions will be a fiasco because conditions
change to such as extent that the plan is no longer relevant and acts as a hindrance.

SCOPE OF BUSINESS FINANCE

In order to understand more clearly the meaning of business finance it is worthwhile to highlight the scope
of business finance. At the outset it may be pointed out that business finance is concerned with finances of
profit seeking organizations only and is important segment of private finance.
Finance, as such is but one facet of broader economic activity of mobilizing savings and directing them in
investments. Finance, includes both public and private finance. Publich finance is the study of principles
and practices relating to acquisition of funds for meeting the requirements of government bodies and
administration of these funds by the government. Contrary to this, private finance concerns with procuring
money for private organisation and management of the money by individuals, voluntary association and
corporations. Private finance therefore comprises personal finance, business finance and the finance of
non-profit organizations. Personal finance seeks to analyze the principles and practices of managing ones
own daily affairs. Study of practices, procedures and problems concerning the financial management of
profit making organizations in the field of industry, trade and commerce and service and mining is
undertaken in business finance. The finance of non-profit organization deals with the practices, procedures
and problems involved in the financial management of educational, charitable and religious and the like
organizations.
Business finance is further split into three categories finances of sole trading organisatoins, partnership
firms and corporate organizations. In the study of business finance emphasis is given to financial problems
and practices of incorporated enterprises because business activities are predominantly carried on by
company form of organisation. That is why subject of business finance is also studied as corporation
finance. It should be remembered that the same principle of finance apply to large and small and
proprietary and non-proprietary organizations nevertheless there are sufficient differences of a specific
operating nature justifying separate consideration of each of these organizations.
The field of corporation finance encompasses the study of financial operations of a business enterprise
right from its very inception to its growth and expansion and in some cases to its winding up also. However,
special attention is devoted to the analysis of the problems and practices involved in raising and utilization
of funds. It should be noted that problems of purchase, production and marketing are outside the purview
of business finance although their problems are so intimately linked to problems of finance that in actual
practice it is difficult to discern them.

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11

FINANCE FUNCTIONS
As hinted in the preceding paragraphs, views of traditional and modern scholars regarding finance function
differ markedly. It would, therefore, be germane to give a brief idea about their views.
TRADITIONAL CONCEPT OF FINANCE FUNCTION
Traditional writers contended that primary responsibility of a finance manager is to raise necessary funds to
meet operating requirements of the business. He has to take decision with respect to the choice of
optimum source from which the funds would have to be secured, timing of the borrowing or sale of stock
and cost and other terms and conditions of acquiring these funds. Planning quantum and pattern of fund
requirements and allocation of funds as among different assets, sais traditional scholars, is the concern of
non-financial executives.
Traditional approach to finance function has been bitterly criticized by modern scholars on various cogent
grounds. One such ground is that the traditional approach is too narrow. It viewed finance as a staff
specially. According to them, it would be mistaken to argue that responsibility of the financial executive is
limited to acquisition of sufficient funds for the enterprise and he has little concern as to how such funds
would be allocated.
Another criticism of traditional approach is that it over emphasized episodic and non-recurring problems
like, incorporation, consolidation, reorganization, recapitalization and liquidation and gave little attention to
day-to-day financial problems of on going concerns.
Another shortcoming of the traditional approach is that it gave concentrated attention to problems of
corporation finance while problems of unincorporated organizations like sole trading concerns and
partnership firms were altogether ignored.
Finally, modern authorities charged that the traditional approach laid relatively more stress on problems of
long-term financing as if business enterprises do not have to encounter any financial trouble in the short
run. As a matter of fact, problem of working capital management is very crucial problem which has to be
dealt with efficiently by the finance manager if an enterprise has to reach the goal of wealth maximization.

MODERN CONCEPT OF FINANCE FUNCTION

Modern Scholars viewed finance as an integral part of the over-all management rather than as a staff
speciality concerned with fund raising operations. Accordingly, finance manager has been assigned wider
responsibilities. According to them, it is not sufficient for the finance manager to see that firm has sufficient
funds to carry out its plans but at the same time he has to ensure wide application of funds in the
productive process. Thus, to carry out his responsibilities it is the bounden responsibility of the finance
executive to make a rational matching of the benefits of potential uses against tht costs of alternative
potential sources so as to help the management to accomplish its broad goal. The finance manager is,
therefore, concerned with all financial activities of planning, raising, allocating, and controlling and not with
just any one of them. Aside from this, he has to handle such financial problems as are encountered by a
firm at the time of incorporation, liquidation, consolidation, reorganization and the like situations that occur
infrequently.
Thus, finance functions, according to modern experts, can be categorized into two broad group Recurring
finance function and Non-recurring finance function. We shall now discuss in detail each of these functions
separately.

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A. RECURRING FINANCE FUNCTION

Recurring finance function encompasses all such financial activities as are carried out regularly for the
efficient conduct of firm. Planning for an raising of funds, allocating of funds and income and controlling the
uses of funds are contents of recurring finance functions. We shall now discuss in brief, each of these
functions.
(1) Planning For Funds
Initial task of the finance manger is a new or going concern is to formulate financial plan for the form.
Financial plan is the act of deciding in advance the quantum of funds requirements and its duration and the
makeup of the requirements to achieve the primary goal of the enterprise. While planning for fund
requirements the finance manager has to aim at synchronizing the cash inflows with cash outflows so that
the firm does not have any resources lying unutilized. Since in actual practice with a synchronization is not
possible, the finance manager must maintain some amount of working capital in reserve so as to ensure
solvency of the firm. The magnitude of this reserve is the function of the amount of risk that the firm can
safely assumes in a given economic and business conditions.
Keeping in view the ling-term goals of the company the finance manager has to determine the total fund
requirements, duration of such requirements and the forms in which the required funds will be obtained.
Decision with respect to fund requirements is reflected in capitalisation. While determining fund
requirements for the enterprise, the finance manger must keep in mind the various considerations, viz.,
purpose of the business, economic and business conditions, management attitude towards risks,
magnitude of future investment programmes, state regulation, etc.
Broadly speaking, there are two methods of estimating funds requirements: Balance sheet method and
Cash budget method. In balance sheet method total capital requirements are determined by totaling the
estimated amount of current, fixed and intangible assets requirements. In contrast, a forecast of cash
inflows and cash outflows in made month-wise and cash deficiencies are calculated to find out the financial
needs under the cash budget method. With the help of cash budget amount of fund requirements at
different time intervals can be calculated.
Having estimated total funds requirements the financial executive decides as to how these requirements
will be met, viz., forms of financing funds requirements. Such decisions are taken under capital structure.
While there may be various pattern of capital structure, the finance manager should decide upon the most
suitable pattern of capital structure for the enterprise.
In order to enable the finance department to perform the aforesaid functions effectively and to achieve the
firms objectives successfully, finance manager must establish suitable policies that act as guides to the
executives of the finance department. Major policy guidelines in this respect are:
a) Policies regarding quantum of funds requirements of the firm.
b) Policies regarding debt equity mix.
c) Policies regarding choice of funds
These policies must be reviewed from time to time keeping in view the changing needs of the firm and
environmental changes.
(2) Raising of Funds
The second responsibility of the finance manager is procuring the requisite capital to satisfy the business
requirements. If the company decides to raise the needed funds by means of security issues, the financial
manger has to arrange the issue of prospectus for the flotation of issue. In order to ensure quick sale of

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securities generally the stock brokers, who deal in securities in the stock market and who are in constant
touch with their clients, are approached.
Even after the issues are floated in the stock market there is no certainty that the security issues will bring
in the desired amount of capital because public response to security is difficult to estimate. If a business
enterprise, fails to assemble the desired amount of funds through security issues, the enterprise is plunged
into grave financial trouble. So as to hamstring this problem the finance manager has to make such
arrangements as may protect the issue against its failure. For that matter, he has to approach underwriting
firms whose main job is to provide the guarantee of buying the shares placed before the public in the event
of non-subscription of the shares. For these services, they charge underwriting commission. Thus, if an
underwriter is satisfied with the issuing company, an underwriting agreement is entered into between the
company and the issuing company. The obligation of the underwriter as per the agreement arises only
when the event of non-subscription of issues by the public takes places.
Where the company decides to borrow money from financial institutions including commercial banks and
special financial corporations, the finance manger has to negotiate with the authorities. He has to prepare
the project for which the loan is sought and discuss it with the executives of the financial institutions along
with the prospects of repayment of the loan. If the institution is satisfied with the desirability of the proposal,
an agreement is entered into by the finance executive on behalf of the company.

(3) Allocation of Funds

The third major responsibility of the finance manager is to allocate funds among different assets. In
allocating the funds, consideration must be given to the factors such as competing uses, immediate
requirements, and management of assets, profit prospects and overall management plans. However, he
has to acquaint the production executive who is primarily seized with the task of acquiring fixed assets with
fundamentals of capital expenditure projects and also about the availability of capital in the firm. But the
efficient administration of financial aspects of cash, receivables and inventories is the prime responsibility
of the finance managers.
The finance executive has also to see that only that much of assets are acquired that could meet the
current as well as the increased demand of the companys product. But the efficient administration of
financial aspects of cash, receivables and inventories is the prime responsibility of the finance manager.
The finance executive has also to see that only that much of fixed assets are acquired that could meet the
current as well as the increased demand of the companys product. But at the same time he should take
steps to minimize the level of buffer stock of fixed assets that the company is required to carry for the
whole year to satisfy the expanded demands. While managing cash, the finance manger should prudently
strike a golden mean between these two conflicting goals to profitability and liquidity of the corporation. He
has to set minimum level of cash so that the companys liquidity is not jeopardized and at the same time its
profitability is maximized. Besides, the finance manager has to ensure proper utilization of cash funds by
taking steps which help in speeding up the cash inflows on the some hand and showing cash outflows, on
the other.
In managing receivables the finance manager should endeavour to minimize the level of receivables
without adversely affecting sales. For that matter, suitable credit policies should be laid down and suitable
collection procedures should be designed.
The operating responsibility of managing inventories in a corporation is outside the province of the finance
manger and well within the realm of production manager and chief purchase officer. However, the financial
manger is responsible for supplying the necessary funds to support the companys investments in

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inventories. In order to ensure that funds are allocated efficiently in inventories, the finance manager must
familiarize himself with various techniques by which efficient management of inventories can be achieved.
The problem that the finance manager faces is to determine the optimal magnitude of investment in
inventories. With the help of the E.O.Q. (Economic Order Quantity) model suitable level of inventories is
decided.

(4) Allocation of Income

Allocation of annual earnings of the company as between different uses is the exclusive responsibility of
the finance manger. Income may be retained for financing expansion of business or it may be distributed to
the owners as dividend as a return of capital. decision in this respect is taken in the light of financial
position of the company, present and future cash requirements of the firm, shareholders, preferences and
the like.
(5) Control of Funds
A finance manger is also responsible for controlling the uses of funds committed in the enterprise. This will
enable him to ensure that fund are being utilized as per the plan. Control function involves development of
standards. Establishing standards is an essential task of the finance manger which requires high degree of
dexterity and skill and the use of sophisticated forecasting techniques. These standards serve as a
concrete basis for evaluation of current performance. Comparison of actual with predetermined standards
provides opportunity to the management to ascertain immediately the discrepancies that have occurred
and take remedial steps before deviations go out of control. If the assessment of the performance reveals
that the actual operations have not conformed to the standards, the reason for this discrepancy may be
traced either in the inadequacy of the firms policies or ineffectiveness of the employees. if the policies are
found to be effective, the finance manager must identify those policies that have not been effective and
suitable and them change such policies so that the firm can accomplish its objectives.
Evaluation work should be performed continuously in view of constantly changing environmental forces.
Whenever and wherever necessary policies should be changed.

B. NON-RECURRING FINANCE FUNCTION

Non-recurring finance function refers to those financial activities that a financial executive has to perform
very infrequently. Preparation of financial plan at the time of promotion of the enterprise, financial
readjustment in times of liquidity crises, valuation of the firm at the time of merger reorganization of the
form and similar other activities are of episodic character. Successful handing of such problems requires
financial skills and understanding of principles and techniques of finance peculiar to non-recurring
situations.

ORGANIZATIONAL FRAMEWORK FOR FINANCIAL MANAGEMENT

Functions of financial management stated above are, by and large, the same in almost all types of
business concerns. However, organisatoin of these functions is not standardized one. It varies from
enterprise to enterprise depending essentially on the characteristics of firm, size, nature convention, etc.
Thus, in similar companies where operations are relatively simple and less complicated and little
delegation of management functions exists, no separate executive is appointed to handle finance
functions. In fact, it is the proprietor who handles all these activities himself. He prepares cash budget for
his firm to assess the requirements and arranges finance to meet these requirements. He himself looks

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after receivables and disbursement work, extends credit, collects accounts receivables, manages cash
accounts and arranges additional funds, in collects accounts receivables, managers cash accounts and
arranges additional funds, in such concerns, finance function is not properly defined and finance function is
combined with production and marketing functions. Financial planning is hardly given important place.
Proprietors have seldom any training in such activities.

With growth in the size of the organisation degrees of specialization of finance function increases. In
medium sized undertakings financial activities are handled by senior management executive who is
designated as treasurer, finance director, finance controller, vice-president in charge of finance. He is
generally given the charge of credit and collection departments and accounting department, investment
department and auditing department. He is also responsible for preparing annual financial reports. He
reports directly to the president and board of directors. His vice in decision making depends in part on his
ability and whether or not his firm is one that is closely held.

In large concerns the finance manager is a top management executive who participates in various decision
making functions, for example, those involving dividend policy, the acquisition of other firms, the
refinancing of maturing debt, introducing a major new product, discarding an old one, adding a plant or
changing locations, floating a bond or a stock issue, entering into sale and lease back arrangements. In
most of the cases the finance manger holds the rank of vice-presidentship reporting directly to the
president and Board of Directors. Place of finance in management hierarchy in large enterprise has been
diagrammatically portrayed in figure 1.2. It appears that a large organisation has finance committee
consisting of some members of Board and a finance manager. The committee makes recommendations for
the final approved of the Board.

Figure 1.2

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In larger concerns, for handling financial matters controller and Treasurer are appointed. Finance controller
is responsible for financial planning and control, preparation of annual financial reports and for carrying on
capital expenditure activities whereas treasures responsibility is limited to raising additional resources for
business purposes, management of working capital and security investment and tax and insurance affairs.
ROLE OF FINANCE MANAGER IN AN ENTERPRISE
Finance manager is an integral part of corporate management of an enterprise and is involved in almost all
the crucial decision making affairs because every problem and every decision entails financial implications.
Finance manager plays significant role in helping the business entrepreneurs and management in
overcoming their business problems and accomplishing their wealth maximization objective. One of the
prime problems facing Corporate management is in the area of capital investments. How much capital
expenditures should the enterprise commit, what volume of funds should be committed and how should
funds be allocated as among different investment outlets are the critical issues which have to be handled
with utmost care failing which the enterprise may land in grave financial crises. The finance manager with
his expertise knowledge management in choosing the most viable project promising maximum results
coupled with minimum risks.
The Central management also faces formidable problem of allocation of funds and they have to strike trade
off between two conflicting but equally important goals of the business i.e. profits vs wealth maximization
Higher the relative share of liquid assets, lesser will be the possibility of cash drain, other things being
equal. However profitability in the case will be less. On the contrary, if a smaller share of funds is held in
liquid form, risk of insolvency will be high but profitability will also be higher. The management is, thus, in
dilemma which the finance manager endeavors to resolve by making use of principles and techniques of
finance.
Another problem plaguing the managemnet pertains to designing such pattern of capitalisation as may be
helpful in maximizing earnings per share and so also the market value of shares. This involves examination
in depth of some of the important issues such as form what sources are funds available, to what extent are
funds available from what sources, what is expected cost of future financing, what sources of funds should
be tapped and to what extent, what financial instruments should be employed to raise funds and at what
time?, which financial institutions should be approached for garnering funds? The finance manager with his
knowledge of finance, capital and Money markets, investors psychology, etc. offers solutions to these
problems.
Once the business is set up and earns profit, the corporate management has to decide about allocation of
earnings between payments to shareholders and rationed earnings. Here again the management is in
dilemma a trade off between growth and dividends, the two equally desirable but conflicting goals of the
enterprise. A satisfactory compromise between the two has to be struck in such a way that shareholders
wealth in the enterprise is maximized. The central management calls upon the expertise of the finance
manager in striking such compromise and helps the management in prudent allocations of income.
Besides handling day to day problems, finance manger also helps the corporate management in
dealing with episodic problems including reorganization, merger, consolidation and liquidation.
Thus, finance manger plays a very significant role in optimal utilization of financial resources in the firm and
thereby ensures the successful survival and growth of the latter.

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DEFINITION OF FINANCE FUNCTION

A. Task of Providing Funds According to these following definitions, the finance function is simply the
task of providing funds needed by the enterprises on suitable terms.
1. In a modern money using economy, finance may be defined as the provision of money at the
time it is wanted.
-

F.W. Paish

2. In an organism composed of a myriad of separate enterprises, each working for its own ends
but simultaneously making a contribution to the system as a whole, some force is necessary to
bring about direction and co-ordination. Something must direct the flow of economic actively
and facilitate its smooth operation. Finance is the agent that produces this result
Husband and Dockery
3. The financing function includes the day-to-day concern for the use and control of funds as well
as long range planning which is involved with determining future requirements for funds and
optimum uses to which they mat be put. The financial policies of the firm are exemplified in its
basic decisions about methods of financing growth, dividend distribution policy, relations with
lending institutions, economic evaluation of alternative investments in plant and equipment and
other activities which involves uses or sources of funds.
-

L.A. and C.E. Gubellini

4. Business finance may be broadly defined as the activity concerned with planning, raising,
controlling and administering of funds used in the business.
-

H. Guthman and H. Douggal

Above mentioned definitions of finance highlight the central core of finance function, i.e., procurement of
funds for the business, but to confine it to this aspect only is a narrow view. It is broader function than that
of funds supply only. It includes the financing decisions, investment decisions as well as dividend
decisions. Financial management is deeply concerned with the economic and effective use of funds.
Therefore, this view cannot be accepted.
B. Management of cash and liquidity According to the following definition finance function is the
management of cash and maintaining the liquidity of funds.
The term finance can be defined as the management of the flows of money through an
organization, whether it will be a corporation, school, bank or government agency. John J.
Hampton. The task of working capital management is not over-all responsibility of financial
management. It is also a narrow concept ant the functions of a financial executive extend to
financial planning, funds raising and administration of funds, etc. If we entrust the financial function
completely to the accountant, it will be a very limited view of finance function. It may be summed up
as the custodian function of finance in the sense that it involves only the proper custody and
authorized utilization of the available funds.
C. Financial decision making Following definitions are concerned with the financial decision
making.

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1. Finance may be defined as the administrative area or set of administrative functions in an

organisation which relate with the arrangement of cash and credit so that the organization may
have the means to carry out its objectives as satisfactorily as possible.
-

Howard and Upton

2. The Finance function is vitally concerned with the use of funds within the business not just the
supply of funds to the business.
-

Hunt, William and Donaldson

In this way finance function covers not only financial planning, financial forecasting, finance raising bout
optimum use of funds as well as the financial control

ROLE AND SCOPE OF FINANCIAL FUNCTION

Financial function seeks to carry out production and marketing functions profitably. These need funds for
investment in fixed assets and current assets. Following are the main financial functions.

MAIN FINANCE FUNCTIONS

1. To estimate the Requirements of Funds Long term as well as Short-term-funds requirement,
the investments in fixed assets and those in various current assets etc. should be estimated
through the techniques of budgetary control and long-range planning. This requires proper forecast
of the physical activities of the organization.
2. To take Finance Decisions or Capital Structure Decisions Each source of funds involves
different considerations regarding cost, risk and control. Keeping these in mind, a proper mix of the
various sources has to be worked out. Long-term funds investments are to provide for the needs of
the core working capital. funds should be procured at optimum costs with the least risk and the
least dilution of control of the present owners. These decisions come under the broad term the
financing decision.
3. To take Investment Decision Long-term funds should be invested in various projects only after
an in depth analysis has been carried out through capital budgeting techniques and uncertainly
analysis. Asset management policies are to be laid down regarding various items of current assets
also. These include policies relating to management of inventories, book debts, cash, trade
creditors etc.
4. To take Dividend Decision From the economic point of view, the amount to be retained or to be
paid to the shareholders would depend on whether the company or the shareholders can make a
more profitable use of the funds. In practice, a large number of other considerations like the trend of
earnings, the trend of share market prices, the requirement of funds for future growth, the cash flow
situation, restrictions under the Companies Act., the tax position of the shareholders etc. are also
kept in mind.

SUBSIDIARY FINANCE FUNCTIONS

1. Supply of funds to all parts of the organization
2. Evaluation of financial performance

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3. Financial negotiations with bankers, financial institutions and other suppliers of credit.
4. Keeping track of stock exchange, quotation and behaviour of stock market prices.
5. Financial Control
6. Keeping the records of all assets.

DEFINITION OF FINANCIAL MANAGEMENT

1. It the application of general managerial principles to the area of financial decision making.
-

Howard and Upton

2. Financial Management is an area of financial decision making, harmonizing individual motives and
enterprise goals.
-

Weston and Brigham

3. Financial Management is the operational activity of a business that is responsible for obtaining and
effectively utilizing the funds necessary for efficient operations.
-

Joseph and Massie

4. In an organism composed of a number of separate activities, each working for its own end out
simultaneously making a contribution to the system as a whole, some force is necessary to bring
about direction and coordination of economic activity and facilitate its smooth operation. Financial
management is the agent that produces this result.
-

Husband and Docker

5. Financial management is concerned with the managerial decisions that result in the acquisition
and financing of long-term and short-term credits for the firm. As such it deals with the situations
that require selection of specific assets (or combination of assets), the selection of specific liability
(or combination of liability) as well the problems of size and growth of an enterprise. The analysis of
these decisions is based on the expected inflows and outflows of funds and their effects upon
managerial objectives.
-

Philippatus

6. Financial Management is the area of business management devoted to a judicious use of capital
and a careful selection of sources of capital in order to enable a business firm to more in the
direction of reaching its goals.
-

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20

CHARACTERISTICS OF FINANCIAL MANAGEMENT

1. Investment decisions These include decisions as regards utilization of funds in one activity or
the other.
2. Financing decisions These include decisions as regards how the total funds required by the firm
are to be raised, namely, by issue of shares, by raising of loans, or by retaining of profits.
3. Dividend decisions These include decisions as regards what part of the profits earned by the
firm is to be distributed among the shareholders in the form of cash dividend, and how much of the
profit are to be retained for utilization by the firm (ploughing back), and
4. Enforcing Financial decision This is done through control and coordination of business
activities.

Thus financial management is an operational function in involving financial planning, financial forecasting
and provision of financial as well as the formulation of financial policies. Hunt, William and Donaldson have
called it Resource Management. In a large organization, the financial manager is the member of the firms
top management charged with the responsibility of planning, organizing, performing and controlling the
financial affairs of the enterprise.

FUNCTIONS OF FINANCIAL MANAGEMENT

The finance functions include Executive or Managerial Functions as Routine Functions. While Executive
functions require skilled planning and execution of financial activities, routine finance functions are chiefly
clerical and are identical to the effective handling of the managerial functions.

1. Executive or Managerial Functions

(i)

Financial forecasting: The financial management arranges that an adequate supply of cash
in available at the proper time for smooth flow of firms activities. As cash-inflow and cash
outflow both are closely related to the volume of sales, it requires financial forecasting. The
estimation of the prospective inflow and outflow of cash in the next quarter or year is
necessary to maintain the liquidity in the funds.

(ii)

Investment Decisions This is the most important executive function of financial executive.
It involves the allocation of capital to various investment proposals in order of their
profitability. The financial manager has little or not operating responsibility for fixed assets,
because these decisions are made by top management. He is however instrumental in
allocating capital to these assets due to his involvement in capital budgeting. As each
investment decision involves risk, a financial manager assets in evaluating the various
proposals in the processes of capital budgeting.

(iii)

Management of Corporate Asset Structure The fixed and current assets of the firm must
be managed efficiently to ensure success. The financial manager is charged with varying
degrees of operating responsibility over existing assets. He is rather concerned with the
management of current assets than with fixed assets. In the management of current assets

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his discretion is not an exclusive one. Other area manages also participate in the formation
of policies regarding the level of investment in various current assets like inventories etc.
(iv)

Management of Income It is a major function of financial executive. It includes the

allocation of net earnings after payment of taxes among shareholders and rationed earning
for employees. the shareholders are generally more interested in current cash dividends. In
order to provide for future contingencies, the top management wants to retain earnings to
the maximum possible extent. The financial manager attempts to arrive at an optimal
dividend pay out ratio that maximize shareholders worth in the long run.

(v)

Management of Cash The cash must be managed for the benefit of the owners. The
financial manager has two objectives (a) how can managers choose the best among the
alternative uses of funds, and (b) how can they ascertain that this is a better use than stockholders could find outside the company? Therefore, the financial manager must select the
most desirable temporary investment for the excess cash and near cash resources of the
firm.

(vi)

Decision about New Sources of Finance A business firm is always in need of funds. On
the basis of forecast of the volume of operations the financial manager should decide upon
the needs and prepare the detailed financial plan both short-term and long-term for the
procurement of funds. He should evaluate the prospective cost of funds as against the
anticipated profits from the use of these funds by the operating units to which they are to be
allocated.

(vii)

Contact and carry Negotiations for New Financing The Financial manger has to contract
the source, carry on the negotiations and finalize the terms and conditions of the contract. In
short term, credit is arranged from a bank, lines of credit are to be opened and financial
executive negotiates with bank authorities in this connection. If long-term funds are needed
additional shares should be issued for it. This requires a number of arrangements to be
made by him.

(viii) Analysis and Appraisal Financial Performance Proper analysis, checking and appraisal of
financial performance is essential to carry out finance function smoothly. Various financial
statements are prepared analyzed and then necessary guide-lines are set for future.
Analysis of what has happened is of great value in improving the standards, techniques and
procedure of financial control.
(ix)

To Advise the Top Management The financial manager advises the top management in
respect of financial matters and suggests various alternative solutions for any financial
difficulty. He makes steady efforts to increase the profitability of capital invested in the firm.

2. Incidental or Routine Functions

Following are routine functions performed by low level assistants like accountants, assistants, accounts
assistants, etc.
1. Record keeping and reporting
2. Preparation of various financial statements
3. Cash management
4. Credit management
5. Custody and safeguarding the different financial securities etc.

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6. Providing top management with information on current and prospective financial conditions of the
business as a basis for policy decision on purchases, marketing and pricing.

IMPORTANCE OF FINANCIAL MANAGEMENT

1. Successful Business Promotion Defective financial plan is one of the most important reasons
of failures of business promotion. It the plan fails to provide sufficient capital to meet the
requirements of fixed and fluctuating capital and to assume the obligations by the corporation, the
business cannot be carried on successfully. Hence sound financial plan is very necessary for the
success of business enterprise. In the words of Hoagland, Unwarranted optimism and lack of
information are more often the cause of faulty financial plans, optimism about the possibilities of an
untried enterprise, and lack of information about the specific needs and limitations. Selection of
sound financial plan requires a serious consideration over factors like profitability, risk and controls
of various alternative plans. This is not possible in the absence of a sound financial management.
2. Smooth Running of Enterprise Sound financial planning is necessary for the smooth running of
an enterprise. As finance is required in promotions, incorporation, development, expansion and
administration of day-to-day working etc. its proper administration is very necessary. This means
the study, analysis and evaluation of all financial problems to be faced by the management and to
take proper decision with reference to these present circumstances in regard to the procurement
and utilization of funds.
3. Coordination of Functional Functions Financial administration provides co-ordination between
various functional areas such as marketing, production etc. If financial management is defective,
the efficiency of all other departments cannot be maintained. If finance department fails in its
obligations, the production and the sales will suffer. Consequently, the income of the concern and
the rate of profit on investment will also suffer. Thus, financial administration controls and coordinates all other activities in the concern.
4. Help in Decision Making Every decision in business is taken in the light of its profitability. Among
a number of alternatives to carryout the decision the management has to select only the best in
terms of its profitability. Financial administration provides scientific analysis of facts and figures
through various financial tools, such as different financial statements, budgets ratio analysis, costprofit-volume analysis etc. These help in evaluating the profitability of the plan in the given
circumstances, so that a proper decision may be taken to minimize the risk involved in the plan.
5. Determination of Business Success The financial managers plan a very important role in the
success of the business organization by advising the top management and presenting important
facts and figures regarding financial position and the performance of various functions of the
company in a given period before the top management in such a way so as to make it easier for the
top management to evaluate the progress of the company and to amend suitably the principles and
policies of the company. By suggesting the best possible alternative out of the various alternatives
of the problem available, the financial managers assist the top management in its decisions making
process.
6. Measure of Performance As J.F. Weston and E.F. Brigham have said, Financial decisions affect
both the size of earnings stream or profitability and the riskiness of the firm. Policy decision affect
risk and profitability and there two factors jointly determine the value of the firm.

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UNIT II
ORGANIZATION OF FINANCIAL MANAGEMENT
Organisation of financial department is the division and the classification of various functions which are to
be performed by the finance department. Finance is one of the important functions of the management.
Financial decisions affect wage policy, inventory policy, labour policy and every other area of decision
making and the reverse is also true. Management decisions are made at every level of business
organisation from president to foreman and nearly management decision involved the finance of the
company.
As finance affects the very existence of a concern, the finance function cannot be decentralized like other
management functions such as personnel, marketing etc. The control and administration of finance should
be given to the top management. Controlling and administrative powers may vest in the Board of Directors
or in the Finance Committee.
The place of finance department in the organization chart depends on the size and the nature of the
business. In a very small business having one man as the proprietor he may make all the management
decision including financial policies. However, in large businesses, a division of responsibility and the
compartmentalization of management are necessary to handle the large volume of work. As finance is one
of the most important functions of management requiring skill and technical expertise, a separate
department for the purpose is established under the charge of an expert in financial matters known as
Finance Manager or Finance Controller or Director of Finance. The Chart No. 2.1 shows an ideal form of
organization for a big business corporation.

FINANCE COMMITTEE
The shareholders, the owners of the corporation control the conduct of the company by electing the Board
of Directors, to whom the management is responsible. Company policies are executed with the help of the
managing director who manages the affairs of the company as per directions of the board. As the
managing director is not an expert of all the matter-labour, market, finance, production etc. relating to the
business, a committee for each function-repairing expert knowledge is constituted for proper guidance and
advice. Thus a finance committee may be constituted to advise the managing director regarding matters
relating to finance of the concern. This may include one or tow directors from the board of directors, the
departmental heads and the chief financial mangers with managing director as the chairman of the
committee. The committee guides and advises the board of directors the control and administration of the
finance.

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STATUS OF FINANCE MANGER

The finance manger is located on the same scalar level as the managers of production department or
marketing department etc. He is full-fledged head of finance department and reports directly to the chief
Directors. He is appointed to look after the activities of the finance department. The controller of finance
and the treasurer are the two officers subordinate to the financial manager. The treasurers responsibility is
to look after the day to day working such as custody of cash and bank accounts, investment portfolio of the
corporation, collection of loans, payments of premiums etc. Cash receipts and disbursements include such
names as Accounts Receivable, Accounts Payable, General Ledger, Internal Audit, Pay-roll, Tax, Credits
and Collections, budget etc. To prevent unauthorized payments made by the treasurer, it must be approved
by the controller. Controller is responsible to the finance committee.
A detailed organisation for finance department can be drawn it the enterprise is to be managed by one
financial officer:

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Fig. 2.2 Organisation of Finance Department

As there is a very wide range of organizational practices the organization structure may change according
to the size and nature of the business. It is also effected by the external factors such as state intervention
in the industrial finance, corporate tax policies etc. Fig. 2.2 shows organization of finance department.

FUNCTIONS OF FINANCIAL MANAGEMENT

The three important activities of a business firm are finance, production and marketing. Through finance
activity the firm secures capital which sis employed through production and marketing activities. This a
business firm engages in activities to perform the functions of finance, production and marketing. It
acquires funds from the sources called investors. When invested, funds are called investments. The firm
expects to receive returns on investments over time. It periodically distributed returns to investors. These
processes are simultaneous and continuous. These are called the finance functions of the firm. These are
as follows:

1. To Raise Funds Funds are two types: equity funds and borrowed funds
(i)

Equity Funds A firms sells shares to acquire equity funds. These represent ownership
rights of shareholders. They invest their money in the shares of a company in the

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expectation of returns on their invested capital in the form of dividend. Shares may be of two
types : common and preference. Preference shareholders receive dividends at a fixed rate
and have a priority over common shareholders in receiving dividends. The dividends rate for
common shareholders is not fixed. It varies from year to year depending on the decision of
the board of directors. The payment of dividends to shareholders is an absolute discretion of
the board of directors.
(ii)

Borrowed Funds An important source of securing capital is creditors or lenders who are
not owners of the company. They supply money to the firm on leading basis and retain title
to the funds lent. Loans are furnished for a specific period at a fixed rate of interest. The
return on loans or borrowed funds is called interest. Payment of interest is a legal obligation
of the firm. Creditors includes banks, financial institutions, debenture holders and others.

2. To Retain Earnings When company secures funds by retaining a portion of the returns available
for shareholders, this method of acquiring funds is called retaining earnings. As the retained
earnings are undistributed returns on equity capital, they are a part of equity capital. The retention
of earnings can be considered as a form or raising new capital. If a company distributes all earnings
to shareholders, then, it can require new capital from the same sources by issuing new shares.
3. To plan investment project The funds raised by a company are invested in the available
investment opportunities called investment project or project. These involve use of funds in the
expectation of future benefits. The company may also have on-going projects which involve outlays
of cash to maintain or to increase their profitabilities. Generation of revenue is possible only when
funds are invested in projects.
4. To carryout all the business activities There is an inseparable relationship between the finance
function and the production, marketing and all kinds of business activities. Directly or indirectly
these involve e the acquisition and use of money. However, it need not necessarily limit or
constraint the general running of the business. A company in a tight financial position will give more
weight to financial considerations.

THE ROLE OF FINANCIAL MANAGER

TRADITIONAL APPROACH
Traditional the scope of financial management and the role of the financial manger were considered
confined to the raising of funds. He was called upon to raise funds during the major events, such as
promotion, reorganization, expansion etc. His only significant duty was to see that the firm has enough
cash to meet its obligations. Till the mid 1950s the finance books covered discussion of the instruments,
institutions and practices through which funds are obtained. These books contained detailed descriptions
of the major events like mergers, consolidations, reorganizations, recapitalizations etc. The traditional view
on financial management was based on the assumption that the financial manager has not concern with
the decisions of allocating firms funds, he is only required to raise the needed funds from the combination
of various resources.
The basic contents of the traditional approach, which also form its limitations, may be summarized as
follows. According to Prof. Solomon.:

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1. To Raise Funds The emphasis in the traditional approach was on raising of funds. The subject of
finance was treated from the investors point of view. The point of view of the financial decision
maker was given no importance. The traditional view, thus, was the outsider looking in
approach.
2. Episodic Function The traditional approach was circumscribed to the episodic financing
function. It placed overemphasis on topics of securities and its markets, promotion, incorporation,
merger etc.
3. Solution of Long-Term problems The traditional approach placed great emphasis on the longterm problems. It ignored the importance of the working capital management.
4. Problem of Non-corporate enterprises The traditional approach used to give significant
attention to the financing problems of noncorporate enterprises.
CRITICISM OF TRADITIONAL VIEW

1. Lack of information of controls and regulations As controls and regulations over firms were
imposed all over the world the management of the firms improved. It started disclosing the financial
information for the purpose of analysis and comparison of performance.

2. Wrong treatment of various problems The traditional approach has been criticized due to its
failure to consider the day-to-day managerial problems relating to finance of the firm.

3. The outsiders point of view The traditional approach concentrated itself to looking into the
problems form lenders the outsiders point of view, instead of looking into the problems from
managements the insiders point of view.

4. Over emphasis on long term planning The traditional approach over emphasized long-term
financing, lacked in analytical content and placed heavy emphasis on descriptive material.

5. Conceptual Omissions The traditional approach neglected the consideration of the question of
the allocation of capital to different assets and the question of optimum combination of finances.
Thus, it omitted discussion on two important matters.
(i)

Financing mix The traditional approach used to give no consideration to the

relationship between financing mix and the cost of capital. it failed to deal with the
question of the optimum combination of finances at which the cost of capital is minimized.

(ii)

Relationship between the valuation of the firm and the cots of capital A theory of
valuation must be used as a basis for computing the cost of capital. the cost of capital is at
the root of allocating the firms funds most efficiently. The traditional approach failed on their
count.

Modern changes in the role of financial manager

1. Shift in emphasis - The traditional approach, outlived its utility in the changed business situation
since the mid-1950s. Increasing pace of industrialization, technological innovations and inventions,
intense competition, increasing intervention of government on account of management inefficiency
and failure, population growth and widened markets etc., during and after mid-1950s required
efficient and effective utilization of the firms resources, including financial resources. As the
development of a number of management skills and decision-making techniques facilitated to
implement a system of optimum allocation of the firms resources, the approach and scope of

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financial management changed. The emphasis shifted from episodic financing to the managerial
financial problems, from raising of funds to efficient and effective use of funds.

2. Analytic approach The modern approach is an analytical way of looking into the financial
problems of the firm. The central problem of financial policy is the wise use of funds. The central
Process involved is a rational matching of advantages of potential uses against the cost of
alternative potential sources so as to achieve the broad financial goals which an enterprise sets for
itself. The basic finance function is to decide about the expenditure decisions and to determine the
demand for capital for these expenditures.

In his new role, the financial manager, is concerned with the efficient allocation of funds.
The three broad decision areas of modern financial manger are investment financing and dividend
decisions. He makes these decisions in the most rational way so that the funds of the firm are used
optimally.
Besides his traditional function of raising money, the financial manager today determines the size and
technology, sets the pace and direction of growth and shapes the profitability and risk complexion of the
firm by selecting the best asset mix and by obtaining the optimum financing mix. He has to look after profitplanning which means operating decisions in the areas of pricing, volume of output and the firms selecting
of product lines.

ORGANISATION OF THE FINANCE FUNCTION IN LARGE FIRMS

As explained in fig. 2.2, In a large organization, the finance function is divided between a treasurer and
controller who, in addition to his usual duties as the chief accounting officer of the firm, is assigned some
staff function relating to finance such as financial forecasting, financial control and financial evaluation of
results. In many large concerns both the treasure and the controller of finance report to a chief financial
officer who often has the title, Vice-President-Finance. The division of finance function between controller
and treasurer is scientific, sound and efficient. The division of finance function between controller and
treasurer is scientific, sound and efficient. While the controller performs and their analysis, etc, the
treasurer is concerned with the routine functions such as recording of inflow and outflow of cash, credit
management, collection of credit sales etc. The vice-president for finance is in close touch with every
important facet of the operations of his department. He is usually on of the senior officers of the firm
reporting directly to the president of the firm. A survey by J.F. Weston in U.S.A. in the year of 1954
revealed that in most of the firms the finance officer reported to the president or the board of directors. In
other cases where he was not a member of the board, he usually attended board meetings in order to
advice and be consulted on financial affairs of the organization. In the year 1962 a survey conducted by
American Management Association revealed that while a majority of the companies have a vice president
of finance, the middle sized companies have both a treasurer and a controller. Smaller companies have
only treasurer. Finance committee is in some large organisation which directly report to the board directors.

STATUS AND DUTIES OF FINANCE EXECUTIVE

The nature of the organization for financial management differs from firm to firm depending on various
factors such as the size of the firm, nature of the business, kinds of financing operations, capabilities of the
firms financial officers and most importantly, on the financial philosophy of the firm.

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1. Financial Manager The designation of the financial officer differs from firm to firm and sometimes
he is known as the financial manager, while at other times he is known president of finance or the
director of finance or the financial controller. Treasurer and Controller may be appointed to assist
him. There may be a vice-president of director of finance, usually with both the controller and the
treasurer reporting to him.

2. Chief Financial Officer The title, vice-president of finance or the finance manger is usually used
for the chief financial officer who has to report diretly to the managing director or the board of
directors or the chief manger of the firm. A firm may have a finance committee consisting of
members of top management with the chief financial officer as a member. The chief financial officer
has both line and staff responsibilities. Concerned with the financial planning and control, he is a
member of top management. Associated with the formulating of policies and making decisions for
the firm, he guides the treasurer and controller and others in the effective working of the financing
department.

3. Treasurer Following are the functions of a treasurer:

(i)

To provide finance The treasurer has to establish and execute programmes for the
provision of the finance required by the business, including negotiating its procurement and
maintaining the required financial arrangements.

(ii)

To Improve Investor relations The treasurer has to establish and maintain an adequate
market for the companys securities and to maintain adequate contact with the investment
community.

(iii)

To Arrange short-term financing The treasurer has to maintain adequate sources for the
companys current borrowings from the money market.

(iv)

To maintain Banking and custody The treasurer has to maintain banking arrangement,
to receive and have custody of financial aspects of real estate transactions.

(v)

To direct Credit and Collections The treasurer has to direct the granting of credit and
the collection of accounts to the company.

(vi)

To plan Investment The Treasurer has to invest the companys funds as required and to
establish and coordinate policies for investment in pension and other similar trusts.

(vii)

To provide Insurances The treasure has to provide insurance coverage as may be

required.

4. Financial controller Following are the functions of Controller of finance

(i)

To Plan and to control The controller has to establish, coordinate and administer, as part
of management, a plan for the control of operations. This plan would provide, to the extent
required in the business, profit planning, programmes for capital investing and for financing,
sales forecasts and expense budgets.

(ii)

To Report and to Interpert The controller ahs to compare actual performance with
operating plans and standards, and to report and interpret the results of operations to all
levels of management and to the owners of business. To consult with all management about
the financial implications of its actions.

(iii)

To Administer Tax The controller has to establish and administer tax policies and
procedures.

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(iv)

To report to the Government The controller has to supervise or coordinate the

preparation of report to government agencies.

(v)

To Protect the assets The controller ahs to assure protection of business assets through
internal control, internal auditing and assuring proper insurance coverage.

(vi)

To appraise economic and social forces The controller has to appraise economic and
social forces and government influences and interpret their impact upon business.

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UNIT III
FINANCIAL PLANNING
Definition of Financial Planning
1. Planning is the process of thinking through and making explicit the strategy and relationships
necessary to accomplish an overall objectives
-

William King

2. The financial plan of a corporation has two-fold aspects : it refers not only to the capital structure of
the corporation, but also to the financial policies which the corporation has adopted or intends to
adopt
-

J.H. Bouneville

3. Financial planning pertains only to the function of finance and includes the determination of the
firms financial objectives formulating and promulgating financial policies and developing financial
procedures
-

Walker and Bougham

Thus financial planning is a process consisting of determining the amount of capital required and the
capital structure and laying down the financial policies. It is not an isolated process but is a part of the
overall planning of any business enterprise.
Following are the three main aspects of financial planning according to Walker and Bougham:
1. Determining financial objectives
2. Formulating financial policies.
3. Developing financial procedure
1. Determining Financial Objectives Financial planning determines the long term and the shortterm financial objectives. This is necessary to achieve the basic objectives of the firm. Financial
objectives guide the financial authorities in performing their duties. Financial objectives may be
long term and short-term.

(I)

Long Term objectives The long term financial objective of the firm is to maximize the wealth
of the concern by uqilizing the productive sources of the firm effectively and economically in
such a way as to increase the productivity of the remaining factors of production over the long
run. Effective utilization of productive factors is possible only if there is a regular supply of funds
at minimum cost. Thus long-term financial objectives include (a) proper capitalization i.e. to
estimate the amount of capital to be raised and (b) determining the capital structure i.e. the
form, relationship and proportionate amount of securities to be issued.

(II)

Short Term Objectives The short-term financial objective of the firm is to arrange for the
necessary funds at proper times as and when they are required by the concern for the smooth
running of the business or for the survival of the firm. It is necessary to maintain the liquidity of
funds in the business.

2. Formulating Financial Policies Financial planning formulates policies to be followed by the

financial authorities with regard to the administration of capital to achieve the long term and shortterm financial objectives of the firm. Financial policies serve as guide posts to those associated with
acquisition, allocation, and control of funds of the firm. In formulating policies, the financial manger

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is required to forecast future in his endevour to predict the viability of the factors which have their
bearing upon the policies. Forecasting is an integral part of financial planning. The following
financial policies are important.
(i)

Policies regarding estimation of capital requirements

(ii)

Policies regarding relationship between the company and creditors

(iii)

Policies regarding the form and proportionate amount of securities to be issued.

(iv)

Policies and guidelines regarding sources of raising capital

(v)

Policies regarding distribution of earnings

(vi)

Policies for the proper administration of fixed and working assets.

3. Developing Financial Procedures Financial planning develops the procedure for performing the
financial activities. Financial activities are subdivided into smaller activities and powers, duties and
responsibilities delegated to the subordinate officers. Proper control on financial performance or
financial control is possible by establishing standards for evaluating the performance and
comparing the actual performance with the standards so established. Steps are taken to control any
deviation from or inconsistencies in predetermined objectives, policies and programmes. Methods
used for this purpose include budgetary control, cost-control, analysis and interpretation of financial
accounts etc.
4. Reviewing Financial Plan As the management reviews the firms short-term objectives, policies
and procedures in the light of changed economic, social and business situation from time to time in
order to keep pace with the changing environment, financial planning is flexible.
IMPORTANCE OF FINANCIAL PLANNING
1. Better Promotion Effective financial planning ensures successful promotion of the business
which is only possible through well thought out flexible financial plan drafted in anticipation of the
establishment of the business.
2. Better Direction Business operations require funds. Successful operation of business depends
on adequate and timely availability of finance for the promotion of business, purchase of assets and
raw materials, production and marketing of goods. Thus the success or failure of a firm is closely
linked with financial planning.
3. Better Conservation of Capital Sound financial planning is necessary for the effective utilization
of capital. plant and machinery acquired by an enterprise become obsolete soon after the arrival of
new machinery in the market with improved technology. Thus, sound financial planning is inevitable
for conservation of capital investment in assets.
4. Better Expansion and Development The objectives of a business enterprise is profitmaximization. This requires the expansion and development of the business unit for achieving its
optimum operational efficiency. Efficient financial planning eliminates financial difficulties in the
future expansion and development of the business.
5. More Liquidity Efficient financial planning makes the firm capable of maintain adequate liquid
funds to meet its obligations to the creditors. Availability of adequate liquid funds prevents the firm
form the situation of over-trading and strengthens its repayment capacity.
6. Higher Return on Capital Employed Sound financial planning leads to effective utilization of
capital by avoiding both under capitalizationB and over capitalization both of which are harmful

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to the financial interests of a corporation. Thus, efficient financial planning leads to higher return on
capital employed by the firm.
7. Optimal Capital Structure at Minimum Cost Efficient financial planning leads to the optimal
capital structure of the firm at minimum cost. In deciding the ratio of different forms of capital in total
capital of the firm, the financial manager ensures that the firm pays the least cost and incurs less
risk. After analyzing the costs and risks involved in different forms of capital, he finally selects those
which involves the least cost without much risk.
8. Better unity and Co-ordination Financial planning leads to the most effective utilization of the
firms capital by establishing effective co-ordination in different operative function and unity in action
by all executives at different levels. Thus, it serves as a guide to effective co-ordination among
various operative function and unity in action. At different levels the executives follow financial
policies, procedures and objectives as set out in the financial plan.
9. Replacement of obsolete assets In the present dynamic economic world, price levels keep on
changing fast rendering the replacement cost of the firms assets much higher than its acquisition
cost. Replacement of obsolete assets is possible only through financial planning.
10. Faster Growth of Public Sector Today growth of public sector has intensified the need for
effective financial planning for the private sector. The public sector enterprises procure borrowed
capital from commercial banks and specialized financial institutions. Hence the private enterprises
find it difficult to obtain the necessary funds from these institutions for financing their plans.
Therefore, the business enterprises should forecast their financial requirements well in advance by
means of effective financial planning.
CHARACTERISTICS OF SOUND FINANCIAL PLAN
1. Simple An ideal financial plan is easily understandable to all. It is free from complications and
suspicions. There are not too many securities likely to create complications in the financial plan and
confusion in the mind of the potential investors about their nature and profitability. Simplicity of
financial plan helps the management in procuring the necessary capital.
2. Foresighted Efficiency of a firms financial plan depends upon the determination of its scope and
size of activities. Thus, financial plan needs to be drafted after estimating the present as well as
future financial requirement of the firm. In order to arrive at a sound financial plan the promoters
use foresight in predicting the short-term and long-term financial needs of the company.
3. Flexible The capital structure of a company should be flexible enough to make necessary
adjustment in it according to the changing circumstances. The flexibility in the financial plan enables
the company to introduce necessary changes to it according to the changing business situations.
The company may need additional capital for financing schemes of modernization, automation,
expansion of business, employee welfare etc. The capital may e increased by issuing new shares
or debentures to the public or by raising loans from specialized financial institutions but reduction of
ordinary share capital is not permissible. Short-term financial requirements may be met by term
loans or issue of redeemable preference share capital. rigidity in capitalization and capital structure
restricts and progress of the business and unnecessarily limits its activities.
4. Liquid To business operations, smooth and reasonable percentage of current assets should be
kept in the form of liquid cash. The business operations may be adversely affected in the absence
of adequate liquid cash. While formulating the companys financial plan, it is necessary to pay
proper attention to the liquidity requirements of a firm which depends upon the nature and size of its
business, its credit standing, goodwill and situation on trade cycles.

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5. Provision for Contingencies A good financial plan has a adequate provision for business
oscillations and anticipated contingencies. Trade cycles are the general phenomenon of the
economic world. During depression period, it is difficult for a company to procure the minimum
amount of working capital by issuing equities as the investors cannot be interested in investing their
savings in equities if there is no guarantee of dividend on them. They would rather prefer to invest
in fixed income securities such as debentures, preference shares, etc. therefore, it is advisable that
the company promoters anticipate the possible contingencies does not always imply the
maintenance of surplus capital. it refers to provision for these contingencies, i.e., either by internal
financing or by issuing new securities.
6. Economical The promoters should always keep in mind the cost of capital procurement while
formulating the financial plan. The various expenses relevant to the issue of capital such as
underwriting, brokerage, discount, printing, etc., should be the minimum.
7. Intensive Use of Capital Effective utilization of capital is as much important as the procurement
of adequate funds. This is possible by maintaining equilibrium in fixed and working capital.
surpluses of fixed and working capital should not be used as substitutes to shortages of one
another. Such practices should not be encouraged as they would drag the company to financial
crises. Thus, intensive use of capital for a fair capitalization. Over-capitalization and under
capitalization both are harmful to financial interests of a corporation.
FACTORS AFFECTING FINANCIAL PLAN
1. Nature of Industry The financial planning of an enterprise is directly related to nature of industry.
While capital intensive industries require large amount of capital, labour-intensive industries
require relatively small amount of capital. stability and regularity in earnings of the industry, variation
in demand of goods manufactured, possibilities of future development, extent of control on
production process, scientific progress, etc., also affect the quantum of capital and sources of
finance of a company. Industries having stability and regularity in earning can easily procure capital
from the market.
2. Size of Industrial Unit Financial plan is affected by size, area of operation, goodwill of managers,
reputation etc. Large sized and old in industries with established goodwill do not face difficult in
raising the needed capital, while newly promoted industries enterprises face a lot of difficulties in
collecting the required amount of capital.
3. Amount of Risks Financial plan is affected by the amount of risks involved in the process of
production of an enterprise. Industries with greater amount of risks need relatively more capital.
these mainly depend upon the ownership securities for the procurement of the requisite capital.
industries with lesser amount of risk can easily obtain loans and earn higher profits for equities.
Industries having more risks and uncertainties do not financial liquidity, and debt-financing usually
harmful to such enterprises.
4. Programme of Expansion Financial planning is affected by the programmes of expansion and
diversification of the business enterprise in future. Thus, while formulating the financial plan, the
promoters should keep in view the future expansion and diversification programmes of the
corporation. In the absence of flexibilities in the financial plan, it is difficult to raise the necessary
capital in future for financing the proposed programmes of expansion and diversification.
5. Capital structure The capital structure of the corporation should be balanced, diversified and of
high grade securities. There should be reasonable balance between different securities. The

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company should retain some ideal securities so that capital may be raised immediately by issuing
them at the time of financial crises.
6. Availability of Alternative Sources of Finance The financial plan of an enterprise depends
upon the availability of the alternative sources of finance at the time of need. The alternative
sources of finance should be appraised in the light of their cost, profitability, control on business,
views of the management etc. Only those sources of finance should be selected which are most
favorable to the firm.
7. Flexibility Flexibility is the main principle to be followed in the financial planning. If there is no
flexibility in financial plans, it would be difficult to carry on its expansion or diversification
programmes due to lack of funds.
8. External Capital Requirement It is good policy for the industry to finance its expansion or
diversification programmes through resources such as ploughing back of profits, reserves and
surplus etc. Short-term finances may be obtained from external sources by issuing redeemable
preference shares or debenture if they are urgently needed.
9. Altitude of Management The financial plan is also affected by the attitude of the management of
the industrial unit. If the existing owners and management wish to retain the control of business in
their hands, they would not like to issue equity shares in large quantity. If they do so, they would
purchase a majority of such shares themselves. They would prefer debt capital even for expansion
or diversification or diversification programmes in future. Ploughing back of profit is preferred in
such business enterprises.
10. Goal Control Government policies, financial controls and statutory rules and regulations should
be considered while formulating a sound financial plan. For example, under the Capital Issues
Control Act., 1956 a company in India is required to obtain the approval of the controller of capital
issues at the time of issuing shares or debentures to the public, and such approval is given only if
the present security mix of the corporation is ideal.
LIMITATIONS OF FINANCIAL PLANNING
1. Not exact Forecasting Being based on financial forecasts, no financial plan can exactly predict
the future economic and business environment. If forecasting is wrong, the financial plan would be
ineffective. Therefore, a financial plan should be periodically reviewed and necessary changes must
be made in accordance with the changing economic and business environment.
2. Lack of co-ordination If there is not effective co-operation and co-ordination among various
officials of the corporation, it is difficult to implement even the ideal financial plan successfully, and
the financial plan proves unsuccessful and ineffective.
3. Changes in Economic Conditions and Govt. Policies Changes in economic condition and
government policies exert adverse influence on the effectiveness of a financial plan.
4. Rigid View If the financial managers follow a rigid view regarding the financial plan of corporation,
and hesitate in making necessary adjustments in it effective financial plan also become ineffective
for want of necessary adjustment according to the changing economic and business conditions.

UNIT IV
CAPITALIZATION
MEANING OF CAPITALIZATION

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1. Broad Meaning In its broad sense, capitalization is synonymous with financial planning, covering
decisions regarding the amount of capital to be raised, the relative proportions of the various
classes of securities to be issued and the administration of capital.

2. Narrow Meaning In its narrow sense, capitalization means the amount at which a firms business
can be valued, the sum total of all long-term securities issued by a company and the surpluses not
meant for distribution. It is composed of the accounting value of the capital stock, value of surplus
not meant for distribution and the value of long term debts. Thus the narrow interpretation of
capitalization deals with only quantitative aspect of financial plan, leaving the qualitative aspect of
financing out of its scope.
Definitions of capitalization
1. Capitalization is the total accounting value of the capital stock, surplus in whatever form it may
appear, and long-term debts
-

Doris

2. The term capitalization, or the valuation of the capital includes the capital stock and debts.
-

A. S. Dewing

3. Capitalization refers to the sum of the outstanding stocks and funded obligaiotns which may
represent wholly fictitious values
-

E.F. Lincoin

4. For all practical purposes, capitalization means the total accounting value of all the capital regularly
employed in the business.
-

G.W. Gerstenberg

5. The term capitalization is used to mean the total of the funds raised on a long term basis, whether
debt, preferred, equity or common equity. The common equity, of course, includes all values
belonging to that interest and not merely stated value of the common stock.
-

Pearson and Hunt

6. Capitalization includes the amount of capital to be raised, the securities through which is to be
raised and the relative proportion of various classes of securities to be issued and also the
administration of capital.
-

W.H. Husband and D.C. Dockerary

CONTENTS OF CAPITALIZATION
1. The value of shares of different classes, i.e., ordinary shares and preference shares.
2. The value of all surplus, whether capital or earned, not meant for distribution.
3. The value of bonds and debentures issued by a company still not redeemed, and
4. The value of long-term loans secured by the company other than bonds and debentures.
CAPITALIZATION AND CAPITAL
Capital and capitalization are two different terms although the term capitalization has been derived from
the word capital. The term capitalization is used only in relation to companies and not in respect of sole
proprietorship or partnership firms. It represents total investment or resources of a company. While the
share capital of a company refers to the total paid up value of shares issued by a company, capitalization

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includes the share capital, debenture stock, long-term debt and the surplus not to be distributed. This
capital is one part of capitalization, as is clear by the following.
Share capital =

Equity Share Capital + preference Share Capital

Capitalization =
Share Capital + Debenture Capital + Long-term borrowing +
Free Reserves
HOW TO ESTIMATE CAPITAL REQUIREMENTS?
Wise estimation of capital requirements of a company is necessary for the smooth functioning of a
business. If the amount of capital is more tan what is really needed to fun the business, a part of funds
would either remain idle or be invested wastefully. On the other hand, if the amount of capital is less than
what is required for the smooth running of business operations the company would face shortage of funds
for one activity or another. In order to avoid both of these situations, the Financial Manager should carefully
examine various requirements of funds by the company for promotion, organization and establishment of
business. However the financial Manager should also keep in mind the future requirements of funds for
expansion and growth of the company, while estimating the total capital needs. On the other hand, while
estimating the capital requirements of a newly promoted company, the financial manager should give due
consideration to the following factors.:

1. Expenses for Promotion Required is case of a new company, these include-expenses incurred
on discovery of business idea and examining its viability, registration of the company, establishment
of organization, commencement of business etc.

2. Cost of Fixed Assets - Fixed assets including land and building, plant and machinery, furniture
and fixtures, etc., need a careful capital requirements estimation.

3. Cost of Current Assets This is the capital requires for financing the acquisition of current assets
such as stocks, debtors, bills receivables, prepaid expenses etc.

4. Cost of Financing Every company has to incur a huge amount of expenditure for raising finance
which include advertisement, listing, brokerage, commission etc.

5. Cost of Fictitious Assets Most of the companies require to pay huge amount for purchase of
intangible assets such as goodwill, patents, trade mark, etc.

6. Cost of Sustenance and Development While in the initial years, a business may need funds to
meet its losses, in later years, it needs funds for diversification, expansion and growth, as well as
for replacement and renovation of old fixed assets, modernization, innovation, research and
development, etc.
THEORIES OF CAPITALIZATION
In order to determine the capital requirements of a newly promoted company the following two theories of
capitalization are generally employed.
1. Cost Theory of Capitalization According to cost theory, the amount of capitalization in equal to
the total cost incurred in setting up of a corporation as a going concern. Thus the estimation of
capital requirements of a newly promoted company is based on the total initial outlays for setting up
of a business enterprise. The amount of capitalization of a company, is determined by aggregating
the following:
(i)

The cost of fixed assets, such as land and building, plant and machinery, goodwill, patents,
furniture and fixture, etc.

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39

(ii)

The amount of regular working capital required to carry on business operations.

(iii)

The expenses of promotion.

(iv)

The cost of establishing the business.

The original outlays on all these items form the basis for determining the amount of capitalization. This
theory enables the promoter to know the total initial amount of capital which they should raise. It is suitable
for determining the financial requirements or the amount of capitalization of a newly promoted corporation.
ADVANTAGES OF COST THEORY
The cost theory is useful for those enterprises in which the amount of fixed capital is more and whose
earnings are regular, such as construction and public utility institutions.
DISADVANTAGES OF COST THEORY
(i)

This theory suffers from the basic drawback that the amount of capitalization is judged by a
figure based on the cost of establishing and starting a business, and not by its earning. It fact,
the amount of capitalization is determined by what a firm earns and not by what ha been
invested in it. This theory does not explain whether the capital invested in a business is justified
by its earnings.

(ii)

This theory is not satisfactory in the case of a growing concern whose earnings keep on
changing whereas the amount of capitalization remains constant.

(iii)

This is not useful for those enterprises in which the operating cost is changing, earnings are not
regular and certain, and which carry on their business under competitive conditions.

2. Earning Theory of Capitalization According to this theory the real worth of a business
enterprise is determined by (i) its earning capacity, (ii) its annual earnings. As the basic objective of
an enterprise is to earn profit, the amount of capitalization for it should be in accordance with its
earnings. The value of capitalization of a company is equal to the capitalized value of its estimated
earnings. Thus, the process of capitalization begins with the estimation of future earnings of the
company. The manager forecasts sales and production costs of the company to arrive at the
estimated earnings which are, then, compared with he actual earnings, of other companies of
similar size carrying on the similar business. Now for determining the amount of capitalization the
rate of earnings in similar companies is applied to the estimated annual earnings of the company.
The amount of capitalization of a company can be computed by using the following formula.
Amount of Capitalization

(i)

Estimated Annual Earnings x Rate of

Capitalization

Annual Earnings The probable earnings of an established company estimated on the

basis of average of earnings during the past year. Real estates of possible future earnings
may be had by considering the various internal and external factors affecting the annual
earnings of the company. It is very difficult to forecast the amount due to the reason that the
earnings newly promoted companies depend upon various other factors besides
capitalization, such as general price level, elasticity of demand, operating costs, extent of
competition, industrial ands tariff policies of the government etc. The net income of the
newly promoted companies may be forecasted on the basis of estimates of operating costs
and volume of sales based on the experience of the promoters or management. For
ascertaining the reliability and accuracy, these estimates should be compared with the
actual figures of costs and sales of existing companies in size, age, location level of
management, rate of growth and other similar factors. After deducting the operating costs

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40

from the operating income the net earnings arrived at may be used for determining the
amount of capitalization.

(ii)

Rate of Capitalization This is necessary for determining the amount of capitalization of a

company. The annual net earnings of a company are capitalized at the rate of capitalization.
It may be determined by studying the rate of return in similar companies in the same
industry. It should reflect adequate return to the investors for the use of their funds and the
risk they undertake. It may be calculated with the help of average price earnings ratio, which
is computed on the basis of income and market value of share of other firms in the industry.
However, determination of capitalization by price-earning ratio is considered suitable only
when the entire capital is raised by issuing shares.
Price Earning Ratio = Price Per Share (Equity Share)
--------------------------------------------Earning Per Share (Equity Share)

OVER CAPITALIZATION
A company is over-capitalized when its earnings are consistently insufficient to yield a fair rate of return on
the amount of capitalization of a company and when it is not in a position to pay interest on debentures and
long-term borrowing, while dividends on shares are not at fair rates, it is said to be overcapitalized. This
situation arises when a company raises more capital than what is justified by its actual earnings. Over
capitalization does not necessarily mean abundance or excess of capital. an over-capitalized company
may be short of capital. A company may be over-capitalized because its capital is not effectively utilized,
thus causing a constant decline in earnings. This leads to the inability of the company to pay normal rate of
dividend and interest on shares and debentures respectively. It leads to fall in the market value of its
shares. A company is overcapitalized if it has been unable to earn a fair or prevailing rate of return on its
capital, and the market value of its shares is lower than the book value over a fairly long period of time.

DEFINITIONS OF OVER-CAPITALIZATION
1. A corporation is over capitalized when its earnings are not large enough to yield a fair return on
the amount of stocks and bonds that have been issued, or when the amount of securities
outstanding exceeds the current value of the assets.
-

C.W. Gerstenberg

2. When a company has consistently been unable to earn the prevailing rate of return on its
outstanding securities (considering the earnings of similar companies in the same industry and the
degree of risk), it is to be over-capitalized.
-

Harod Gilbert

3. Whenever the aggregate of the par value of stock and bounds outstanding exceeds the true value
of fixed assets, the corporation is said to be over-capitalized.
-

Hoagland

CHARACTERISTICS OF OVER-CAPITALIZATION
1. Lower rate of earning than prevailing in similar companies in the same industry over a fairly long
period of time.

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2. Lower rate of dividend over a long period of time.

3. Lower market value of shares than the book value of shares over a long period of time.
CAUSES OF OVER-CAPITALIZATION
1. High Promotional Expenses A company has paid high promotional expenses in the form of
payments to promoters for their services, and excessive price for goodwill, trade marks, patents,
copyright etc. Similarly, if the company is formed by converting a partnership firm or a private
limited company into a public limited company and the assets transferred at highly inflated prices,
the company will be over-capitalized because the book value of the companys assets will be higher
than its real value.
2. Purchase of assets During Inflationary Conditions Inflationary conditions affect both the newly
promoted as well as the established companies. companies have to pay high prices for purchase of
fixed assets, and the amount of capitalization is kept high during boom period. But after the boom
conditions subside and necessary conditions set in, the real value of the companys assets fall while
the book value of its assets remain at a higher level therefore, the company becomes overcapitalized.
3. Raising Excessive Capital Over capitalization occurs if a company raises excessive capital
than what it can utilize effectively. As a large amount of capital remains idle and ineffectively
utilized, the companys earnings decline leading to fall in market value of its shares.
4. Shortage of Capital Paucity of capital is the result of faulty financial planning. If compels the
company to borrow capital at very high rates of interest. A large chunk of profits is given away to the
creditors as interest leaving little to be distributed to the shareholders as dividends. As the rate of
dividend falls the market value of shares also fall showing over-capitalization.
5. Borrowing at Higher Interest Rates To meet its emergent needs if a company borrows a large
amount of capital at a rate of interest higher than the rate of its earnings it will be over-capitalized.
As a major part of its earnings will be taken away by the creditors as interest, the rate of dividend
will fall, and the market price of shares would decline. Thus, lower market price of shares than the
book value makes the company over-capitalized.
6. Over-estimate of Future Earnings As the promoters of mangers over-estimate the earnings of
the company, it results in over-capitalization.
7. Over-estimate of Capitalization Rate A company would be over-capitalized if the earnings are
correctly estimated but the rate of capitalization is under-estimated. Underestimate of the rate of
capitalization results in raising excessive capital than what the company could utilize profitably
making the company unable to distribute dividends at prevailing rates. This leads to decline in the
market value of its shares which is a symptom of over-capitalization. For example, if a companys
regular earnings of Rs. 1,50,000 and capitalized at 6% the total amount of capitalization would be
Rs. 25,00,000. If later on, it is found that the rate of capitalization is 10% instead of 6%, the amount
of capitalization should be Rs.. 15,00,000. Thus, the excess amount of Rs. 10,00,000 would lead to
over-capitalization.
8. Inadequate Provision for Depreciation Due to inadequate provision for depreciation and
replacement of assets, a company is able to distribute higher dividends to its shareholders only for
a few years. However, with the passes of time the working efficiency of fixed assets decreases
resulting in a fall in the earning capacity of the company. Therefore, the share prices of the
company show a declining trend indicating over-capitalization.

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9. Liberal Dividend Policy If, instead of ploughing back its profit a company prefers to follow a
liberal dividend policy it would find it difficult to replace its worn-out assets with sufficiently
decreased working efficiency. It will be compelled to resort to costly borrowing which adversely
affects its earning capacity. The combined effect of these factors leads to company to overcapitalization over a long period of time.
10. Rigorous Taxation Policy Rigorous taxation policy of the Government results in overcapitalization. Due to higher tax burden, very little amount is left with the company for dividend
distribution among the shareholders at prevailing rate, a symptom of over-capitalisation. The
company may face shortage of funds form both working capital as well as for financing the
renewals and replacement of worm-out assets. Thus, the working efficiency of the company
decreases. The prices of its shares fall resulting in the companys over-capitalization condition.
DISADVANTAGES OF OVER-CAPITALIZATION
1. DISADVANTAGE OF THE COMPANY
(i)

Set back in the Value of Shares and Goodwill Because of decrease of in the earning
capacity of the company, a large majority of investors lose their confidence in the company.
The market value of its shares comes down and the companys financial stability is
jeopardized. It also suffers a set back to its goodwill.

(ii)

Set back Obtaining Capital -Because of fall in dividends the investors lose their confidence
in the company resulting in difficulty to obtain the requisite capital for improvement and
acquisition of new assets by issuing shares or debentures.

(iii)

Set back in obtaining Loans The credit standing and goodwill of an over-capitalized
company suffers a set back due to falling earnings. Financial institutions hesitate in
providing loans to such a company for its development and expansion programmes.

(iv)

Manipulation of Accounts An over capitalization company resorts to objectionable

practices including manipulation of accounts in order to cover up the deficiency of the
decreased earnings and to present a respectable figure of profits. It does not make
adequate provisions for depreciation, maintenance, renewal and replacement of asset. It
even declares and pays unearned dividends from capital to revive its decreasing credit
standing. This further aggravates the decreasing value of the company besides misleading
the investors.

(v)

Demand for Liquidation An over-capitalized company is not able to pay the principle
amount of loan and interest there on. Therefore, the creditors may forcefully demand
liquidation of the company, unless drastic steps are taken to correct the situation.
Reorganization of the companys share capital, is one effective remedy leads to
considerable loss of its goodwill.

(vi)

Absence of Competitive strength Due to its failure to produce goods at competitive cost
on accounts and inadequate provision for depreciation, repairs, maintenance and
replacement of assets an over-capitalized company loses its market to competitors. Such a
company is unable to provide facilities to their customers equal to its competitors. Therefore,
it fails to retain its customers and lose the market.

2. Disadvantages to shareholders

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(i)

Low Dividend The shareholders of an over-capitalized company suffer a revenue loss

due to low return on their investment in the form of low dividends on account of low earnings
of the company.

(ii)

Low Market value of Shares The shareholders suffer a capital loss on account of low
market value of shares. They have to sell their share below par, suffering a capital loss
through depreciation of their investments.

(iii)

Loss on Re-organization or Liquidation If an over-capitalized company attempts to

overcome its ills by re-organization or liquidation, the shareholders are the worst sufferers.
Re-organization calls for reduction in capital for writing off past losses, leading the reduction
of par value of shares resulting in depreciation of the shareholders investments. If an overcapitalized company is forced by its creditors to go into liquidation, the shareholders are the
recipients of the residual amount left after the payments to creditors. Sometimes the
shareholders have to forego the entire amount of their investments in case of liquidation.

(iv)

Low Value of Shares as Collateral Securities As the shares of an over-capitalized

company are not easily marketable due to low earnings and lower dividends of the
company, they have a lower value as collateral securities. Commercial banks and other
financial institutions are not willing to sanction loans against such securities. Even if they
agree to grant such loans, they insist upon strict terms and conditions hardly acceptable to
an ordinary borrower.

(v)

Encouragement to Speculative Gambling As the low-priced shares of an overcapitalized company are subject to speculative gambling, the real investors have to suffer on
account of this manipulation.

3. DISADVANTAGES TO SOCIETY

(i)

Lower Quality and Higher Prices An over-capitalized company does everything to

increase its earnings. It reduces the quality and increases the price of products. The ultimate
consumers suffer in terms of both quality and price and have to pay high prices for poor
quality products.

(ii)

Reduction in Wages and Labour Welfare Activities Over capitalization leads to

retrenchments and reduction in wages and salaries. An over-capitalized company tries to
cut the wages and welfare facilities of the workers creating soreness in industrial relations.
The interests of the workers suffers due to substantial cuts in wages and other benefits. An
over-capitalized company often resorts to retrenchment of the workers on grounds of low
earnings in the company.

(iii)

Recession Due to low purchasing power of workers, demand for goods comes down. As
this process continues recessionary conditions are witnessed.

(iv)

Unemployment Finding it difficult to survive in the competitive market over-capitalized

companies is often forced to close down. The closure of a few over-capitalized companies
tends to create panic in general. Industrial activity receives a set back. The consumers are
deprived of goods and services. The creditors lose their credits. The workers lose their jobs.
The society is confronted with a depressing effect in general.

(v)

Mis - utilization and Wastage of Resources An over-capitalized company is unable to

effectively utilize the societys resources. Thus over capitalization leads to the wastage of

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national resources which could be used most effectively by those efficient companies who
are in need of funds.

(vi)

Encouragement of Speculation The shares of an over-capitalized company are

invariably subject to speculative gambling.

(vii)

Frustration Among Investors Over-capitalization leads to reduced efficiency and

possibility of failure of the business. Therefore, the investors are not willing to invest in such
a company. The industrial and economic development of the country is adversely affected.

REMEDIES TO OVER-CAPITALIZATION
Following are the remedies to over-capitalization:

1. Reduced Funded Debt To control the situation of over-capitalization, a company reduces the
amount of funded debts through outright re-organization. Debentures and bonds are immediately
redeemed out of accumulated earning or new issues. However, as the profits of an over-capitalized
company are very low, it is very difficult for it to raise the necessary funds from the market. If it issue
its shares at a discount, it may do more damage to the company. Thus, reduction in capital may be
affected only by retiring the funded debts out of accumulated earnings.

2. Reduced Interest Rate in Debentures An over-capitalized company tries to reduce its fixed
obligation with regard to payment of interest on debts. It persuades the existing debenture holders
to accept new debentures carrying lower rates of interest, on some premium for this concession.

3. Redemption of Preference Shares The amount of capitalization may be reduced by redemption

of performance shares carrying high rate of dividend. This poses the same problem as in case of
redemption of debentures by issuing new shares at a reduced price. Raising of necessary funds for
redeeming the high dividend preference shares may further aggravate the situation.

4. Reduced Par Value of Shares The existing shareholders are persuade to accept new shares
with reduced par value. This reduces the amount of capitalization and improves the earning
capacity of the company. However, this is possible only if the management is able to convince the
existing shareholders that reduction in par value of shares is in their interest.

5. Reduced Number of Shares A company sometimes reduces the number of shares to correct the
situation caused by over-capitalization. The shareholders may be given one share of the same
amount in exchange of several shares. Thus earning per share goes up without affecting the
amount of capitalization. This helps the company in raising the necessary funds for future
development.

6. Ploughing Back of Profits In the initial stage of over-capitalization, the company may resort to
the ploughing back of profits by suspending the distribution of dividends for a few years. This
increases the amount of its real value without an extra burden on its resources. The management
should make all-out efforts to eliminate wasteful expenditure and to increase the efficiency of the
companys resources.
UNDER CAPITALIZATION
MEANING OF UNDER CAPITALIZATION
Under capitalization is the reverse of over-capitalization. A company is under-capitalized when its
earnings are high in relation to other similar firms in the industry, or when it has very little capital to conduct
its business, or when the real value of asset are more than the book value. under-capitalization is

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associated with an effective utilization of investments, an exceptionally high rate of dividend and prices of
shares. It is a condition where the real value of the companys assets is more than the book value.
DEFINITIONS OF UNDER CAPITALIZATION
1. A Corporation is under-capitalized when the rate of profit it is making on the total capital, is
exceedingly high in relation to the return enjoyed by similarly situated companies in the same
industry, or when it has too little capital with which to conduct its business.
-

C.W. Gerstenberg

2. When a corporation earns exceedingly high income on its capital, it is said to under-capitalized.
-

Bonnevile and Dewy

3. When a company is earning considerably more than the prevailing rate on its outstanding
securities, considering the same factors, it is said to be under-capitalized.
-

G. Harold

Following are the Symptoms of under-capitalization

1. Higher rate of Earning The rate of earning is exceedingly higher than prevailing is similarly
situated companies in the same industry.
2. Higher rate of dividend This is as compared to the rate declared by other similar companies.
3. Higher Value of Shares The real and market value of shares is higher than their book value.
4. Higher value of Assets The real value of the companys assets is higher than their book value.
CAUSES OF UNDER CAPITALIZATION
1. Under Estimation of Earning The amount of capitalization is less than what a company can
utilize effectively, if the promoters under-estimate the future earnings of the company while
formulating the financial plan. The company becomes under-capitalized as the earnings in
subsequent years prove to be higher.
2. Under-estimation of capital requirements If the promoters under-estimate the capital
requirements of the company, the amount of capitalization if low. Thus, the company becomes
under-capitalized due to inadequacy of capital.
3. Promotion during Recession If a company is promoted during the period of recession, it may
acquire the assets at cheaper prices. The real value of the assets automatically goes up with the
end of recession. Thus, during boom period its earnings increase proportionately higher than the
increase in the amount of capital employed, resulting in high profits to the company and
exceptionally higher rate of dividends as well as higher market price of its shares making the
company under-capitalized.
4. Unforeseen Increase in Earnings Due to government liberal policy towards a particular industry,
or increases in sale price of the product due to sudden increase in its demand, the earning of a
company may increase abnormal making in under capitalized.
5. Conservative Dividend Policy If a company follows a sound and conservative dividend policy
leading to the creation sufficient reserves for depreciation, repairs and renewals, and the ploughing
back of profits, its earnings increases tremendously, and real value of its assets exceeds their book
value indicating under-capitalization.

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6. Promoters Desire to Control If the promoters of a company seek to retain its control within the
hands of a few persons, they issue lesser number of shares, and raise a large portion of its capital
by issuing securities bearing low rate of interest. The amount of divisible profits available to the
shareholders is exceptionally high and the company becomes under-capitalized.
7. High Standard of Efficiency If a company follows the policy of rationalization and modernization
entailing the use of latest production technique and efficient management of resources, its profits
invariably increase exceedingly. It may also increase it earnings by creating large secret reserves,
ploughing back of profits, maximizing productivity, minimizing wasteful use of resources, etc. As a
result the real value of its assets becomes much higher than their book value, and the company
becomes under-capitalized.
8. Low Promotion Expenses The company will become under-capitalized if the promoters do not
charge excessive amounts for their promotional services and the over-all promotional cost is kept
very low.
9. Liberal Policy Due to low tax burden, sufficient amount is left with the company for higher
dividend distribution, a symptom of under-capitalization. Liberal tax policy enables the company to
increase its working efficiency by maintaining adequate reserves of financing the renewals and
replacement of worn-out assets.
10. Capital Gains If a companys assets are sold by the management at higher price than their book
value, the resultant capital gains lead the company to under-capitalization.
DISADVANTAGES OF UNDER-CAPITALIZATION
1. DISADVANTAGES TO THE COMPANY
(i)

More Speculation A high divided rate on the shares of an under-capitalized company leads
to high market quotations of these shares. The management may manipulate share values and
enter into speculation of these shares.

(ii)

Limited Marketability of Shares As the existing shareholders do not generally want to

dispose off such shares, the marketability of an undercapitalized companys share is
considerably reduced.

(iii)

Cut throat competition As higher earnings of the existing under-capitalized companies

attract new competitors to enter the business, cutthroat competition among rival companies
tends to grip the business and reduce its profitability.

(iv)

Industrial Unrest Industrial relations in under-capitalized companies tend to be strained on

account of the fact that employees begin to ask for higher wages, bonus, reduced working
hours, increased welfare facilities etc., out of he increased prosperity of the company in the form
of higher earnings. This leads to industrial unrest which adversely affects the efficiency of the
corporation leading to decline in its profits.

(v)

Consumers Opposition Due to high earnings, the consumers of an under-capitalized

company feel that they are being cheated by overcharging the prices for its products. This may
lead to the consumer agitations for a reduction in prices of the products offered by an
undercapitalized company. They may demand state intervention to control the prices of the
products of such a company. This would result in reduction in the profits of the company.

(vi)

Interference by Government Declaring a high rate of dividend, an Under-capitalized

company attract the government interference to cut down the prices of its products, to profit

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ceiling, to charge high profit taxes or file a suit against such a company under anti-trust laws of
the country.
(vii)

Inadequacy of Capital Suffering from shortage of capital an under-capitalized company

always depends on borrowed funds. Sometimes, it is compelled to borrow funds at a high rate
of interest resulting in reduction of its earnings and control by its creditors, who may even
demand for its liquidation in case of non-payment of interest and the principal amount of loan.

(viii)

Over-capitalization Under-capitalization also leads a company to over-capitalization in the

long-run due to huge retained earnings and long-term debt financing.

ADVANTAGES OF UNDER CAPITALISATION

A. ADVANTAGES TO SHAREHOLDERS
1. Higher Dividends The shareholders of an under-capitalized company regularly receive higher
dividends on their investments, due to higher earnings of the company.
2. More Capital Gains The shareholders of an under - capitalized company also avail more capital
gains, because the market value of the companys shares increase very rapidly.
3. Easier Loans As the shares of an under-capitalized company have great value as collateral
security, the shareholders get easier loans against the security of shares of an under-capitalized
company.
B. ADVANTAGES TO SOCIETY

(i)

General welfare The entire society is benefited with the higher earnings of an undercapitalized company

(ii)

Employees advantage The employees get higher wages, bonus and better amenities.

(iii)

Increased Production Under-capitalization encourages the establishment of new companies

resulting in increased industrial production and ensuring regular supply of quality goods to the
consumers at cheap prices.

(iv)

Increased employment Establishment of new companies and expansion of the established

ones creates increased employment.

REMEDIES TO UNDER-CAPITALIZATION
Following are the remedies to under employment

1. Splitting up of Shares The shares of an under-capitalized company may be splitted into shares
of small denomination bringing down the amount of divided per share without affecting the total
earnings and the amount of capital of the company.

2. Increase in Par Value of Shares In exchange for the old shares a company may issue shares of
higher par value to its existing shareholders. While establishing parity between the par value and
the market value of the companys shares this brings down the rate of dividend without affecting the
amount of dividend per share.

3. Issue of Bonus Shares The most prevalent remedy to under-capitalization is to capitalize the
retained earnings of the company by issuing bonus shares increasing the share capital as well as
the number of shares of the company. That, the rate of dividend per share comes down.

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4. Issue of Shares and Debentures Under capitalized due to the inadequacy of capital, company
may raise more capital by issuing shares and debentures. This increases the share capital and
number of shares of the company resulting in decline in the rate of dividend.
IMPACT OF OVER CAPITALIZATION
Over capitalization is harmful to the financial interests of the company as it adversely affects the financial
structure of the concern and the interests of shareholders and consumers. The share holders lose in terms
of capital and dividend. The employees are deprived of their fair compensation and stand to lose their jobs.
The consumers suffer in terms of reduced quality and increased prices. The society finds that its resources
are being misused. The remedies available to correct the situation of over-capitalization are quite painful.
The financial re-organization of the company involves considerable sacrifice on the part of its shareholders.
If the company goes into liquidation the shareholders and creditors suffer a considerable loss.
IMPACT OF UNDER CAPITALIZATION
Under-capitalization is undesirable business it accelerates, competition, breeds discontent among the
employees, accentuates the feeling of exploitation among consumers and tempts the management to enter
into speculation of the companys shares. However, under-capitalization also possesses some welcome
features. The shareholders and the society enjoy the prosperity of an under-capitalized company. Even the
employees and the consumers gain from the increased efficiency of the company. It is easier to remedy
under-capitalization by capitalizing the companys surpluses.

1. Impact on Shareholders

Over Capitalization

Under-capitalization

a. A lower rate of return

a. High rate of earning per

share

b. Uncertain
income

and

irregular

b. Capital value of the share

is increased

c. Capital value of the shares

is reduced
c. Wide
market
d. Speculation in shares
shares

fluctuations
in
value of such

2. Impact on Company

a. The credit worthiness of a. It

induces
the
such company is reduced
management to build up
secret
reserves
and
b. Maintenance,
renewals
under-state earnings
and
replacement
programmes
are b. The high rate of earnings
suspended
per share may increase
competition
c. Loss
of
goodwill
manipulation to account c. The employees demand
etc.
high
share
in
the
increased profits of the
d. Morale
of
the
company
management employees
is low

3. Impact on Society

a. The quality of the product

is effected

a. The consumers are not

benefited even in this
state. Management builds
b. In the long-run such
up the reserve, etc.
concerns are liquidated

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49

c. Loss of employment as b. The

government
can
well
as
production
charge excess profit-tax
capacity.
from such companies.
REMEDIES LEADING UNDER-CAPITALIZATION TO OVER CAPITALIZATION
1. Increase in profits and Book value Under-capitalization is characterized by an exceedingly high
rate of profit enjoyed by a corporation in relation to other similar firms in the industry. The entire
profits of the company are not distributed among its shareholders as dividend, but a large part of its
profits are retained in the business in the form of reserves and surpluses. Thus, a large part of
profits is accumulated with the company, which forms a part of its capitalization. As profits of a
company belong to shareholders, the retained earning in the form of reserves and surpluses
constitutes a part of the companys capitalization, and the book value of the company is arrived at
by adding this amount to the capital of the company. Retained earnings being a fixed liability of the
company, the book value of its assets exceeds by their real value in the market which is the state of
over-capitalization. Thus, in due course under-capitalization leads to over capitalization.
2. Decrease in share capital and dividend As under capitalized company has lesser amount of
were capital and it has to depend on long-term borrowing for its expansion development
programmes, due to increased amount of risk to the creditors, the company has to pay higher rates
of interest, which leads to reduction of its profits. Thus the company fails to pay dividends at
generally prevalent rates. Due to lower dividend rate, the market value of the companys shares
comes down. The real value of its assets is reduced to below their book value. thus, the company
becomes over-capitalized. Thus, Under capitalization leads to over-capitalization in due course of
time. The practice of under-capitalization results in marking a concern over-capitalized.

MEANING OF WATERED CAPITAL

When the real value of its assets is less than its paid-up share capital, a part of the capital is not
represented by its assets, and the companys capital is termed as water capital as worthless as a water.
According to Hoagland, A stock is said to be watered when its true value is less than its book value. Thus,
a companys capital is watered when the total amount of its paid-up share capital is not represented by the
same value of its asset. Watered capital means that the realizable value of the companys assets is less
than its paid-up share capital.

CAUSES OF WATERED CAPITAL

Following are the causes of Watered Capital
1. Purchase or Transfer of Assets at Inflated Price As a company purchases or transfers assets
from a going concern at inflated prices, its capital becomes watered to the extent of the excess
price paid for the assets making the book value of assets more than their realizable or market
value.
2. Investment in Intangible Assets If huge investments are made in acquiring intangible assets
such as goodwill, parents, copyright, trademarks, etc., at the time of promotion, and later on they
prove worthless or lose their utility for the company, its capital becomes watered as the real value of
the intangible assets is less than their book value.

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3. Over valuation of Promoters Services The capital of the company becomes watered if the
services of the promoters are valued at a very high price and paid for by issuing them fully paid-up
shares of that amount.
4. Defective Depreciation Policy Defective depreciation policy may contribute in making the
companys capital watered. It makes the book value of the assets bigger than their market value
due to inadequate provision for wear and tear, depreciation and other losses.
5. Unforeseen Changes or Accidents Watered capital occurs due to result of unforeseen internal
or internal changes or accidents such as fall in the real of shares due to decline in profits,
inflationary condition etc.

CONTROL OF WATERED CAPITAL

Irrespective of the causes of watered capital, it is always unproductive and it does not command any
earnings capacity. As watered capital adversely affect the company, the management should take following
stern steps to correct it:

1. Ploughing Back or Profits Watered capital may be corrected by ploughing back a substantial
part of the companys profits for some years correcting the difference between the realizable value
and book value of the companys assets.

2. Adequate provision for depreciation The watered capital will come down and finally eliminated,
if the value of fixed asset is gradually reduced to the extent of their depreciation.

3. De-capitalisation If the par value of the shares held by the existing shareholders is reduced, the
deficiency of capital may be written off by the resultant capital gain.
WATERED STOCK
When stock is not represented by assets of equivalent value, it is designated as Watered stock signifying
dilution of water in the capital of the enterprise. More often than not, services of promoters are valued
highly and are accordingly paid usually in the form of stocks. Under these circumstances, existence of
water in the stock cannot be ignored nevertheless the earning capacity of the enterprise may justify the
payment at exorbitant price. Similarly when an enterprise pays higher price to the vendors for the assets
transferred, the enterprise will be in the state of watered stock.
So as to test the existence of water in stock, the analyst should study the intent of the promoters who float
the enterprise and sell the stocks. If the promoters deliberately acquire the assets needed by the enterprise
at inflated price, state of watered stock is said to have existed.

WATERED STOCKS VS. OVER-CAPITALIZATION

Sometimes the term Watered Stock is confused with overcapitalization. However, there is a clear-cut
difference between the two. While the state of watered stock relates to promotion of an enterprise, a
company gets over-capitalized only when it fails to earn sufficient income to justify its capital. thus, at the
time of promotion, an enterprise is expected to acquire the assets at a price which represent their real
worth. In case the assets acquire prove worthless or they have been bought at an inflated price, stock of
the enterprise will become watered stock. In contrast, when an enterprise has run for several years and
during all these years it has not been able to make sufficient earnings to justify its capital, the enterprise
will be in the state of over-capitalization. It is important to note that state of watered stock may become
potent cause for the existence of over-capitalization in the enterprise.

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The above distinction can be made more clear with the help of the following example:
The Good Luck Company issues 500 shares of Rs. 200/- each. Issues are fully subscribed. This sum (Rs.
1,00,000) is utilized to acquire fixed assets for the corporation. At the time of promotion of the enterprise, it
is discovered that realizable value of assets is Rs. 80,000. It means that the stock of the company has
been watered to the time of Rs. 20,000. However, the company has run successfully for the past five years
and has, on an average, earned Rs. 15,000 yearly. If earnings are being capitalized at 5% rate, the
capitalized value of earning will be Rs. 3,00,000, it suggests that the company having watered stock is not
over-capitalized. On the other hand, the company may receive the assets of full value of Rs. 1,00,000 but it
makes an average earnings of Rs. 4,000 which is being capitalized at 5% rate giving capitalized value of
earnings equal to Rs. 80,000. It means that although the company has no water in stock, it is overcapitalized. Thus, watered stock is concerned with the realizable value of the assets which can be had by
liquidating the assets in market, whereas over and under-capitalization are relative terms which are related
with real value of assets determined by the actual earnings capacity of the company.

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UNIT V
CAPITAL STRUCTURE
MEANING OF CAPITAL STRUCTURE
Capital structure of a company cannot be the composition of long-term sources of long-term sources of
funds, such as ordinary shares, preference shares, debentures, bonds, long-term funds. It implies the
determination of form or make-up of a companys capitalization.

DEFINITIONS OF CAPITAL STRUCTURE

1. Capital structure is the permanent financing of the firm, represented primarily by long-term debt,
preferred stock, and common equity, but excluding all short-term credit. Common equity includes
common stock, capital surplus and accumulated retained earnings.
-

Weston and Brigham

2. The term capital structure is frequently used to indicate the long-term sources of funds employed in
a business enterprise.
-

Robert H. Wessel

3. From a strictly financial point of view, the optimum capital structure is achieved by balancing the
financing so as to achieve the lowest average cost of long term funds. This, in, turn produces the
maximum market value of the total securities issued against a given amount of corporate income.
-

Guthman and Dougall

4. Capitalization embraces the composition or the character of the structure as well as the amount
-

Husband and Dockeray

5. Capital structure refers to the kind of securities that make up the capitalization.
-

W. Gerstenberg

6. The term capital structure is frequently used to indicate the long-term sources of funds employed in
a business enterprise.
-

R.H. Wessel

7. Capital structure is the combination of debt and equity securities that comprise a firms financing of
its assets.
-

John J. Hampton

DISTINCTIONS BETWEEN CAPITALIZATION AND CAPITAL STRUCTURE

1. Difference in scope Capitalization refers to the total accounting value of all the capital regularly
employed in the business, which includes share capital, long-term debt, reserves and surplus. On
the other hand capital structure refers to the proportion of different sources of long-term funds in the
capitalization of a company.
2. Difference in objectives Capitalization is concerned with the determination of the total amount of
capital required for the successful business operation, on the other hand capital structure is
concerned with the determination of the composition of different long-term sources of funds, such

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as debentures, long-term debt, preference capital and ordinary share capital including retained
earnings.
In order to maximize the shareholders wealth, the financial manager should attempt to achieve an optimal
capital structure which refers to an ideal combination of various sources of long-term funds so as to
minimize the overall cost of capital and maximize the market value per share. The optimum capital could
be achieved when the marginal cost of each source of finance is the same. It is incorrect to say that there
exists an ideal mix of debt and equity capital which will produce an optimum capital structure leading to the
maximization of market price per share. There is no single optimal capital structure for all firms, or for the
same firm for all times. The financial manager should attempt to develop an appropriate capital structure
for his firm instead of trying for un utopian optimal capital structure.
CHARACTERISTICS OF OPTIMAL STRUCTURE
Following are the characteristics of an optimal of capital structure.
1. Simplicity A sound capital structure is simple in the initial stage are which limits to the of the
number of issues and types of securities. If the capital structure is complicated from the very
beginning by issuing different types of securities, the investors hesitate to invest is such a company.
The company may also face difficulties in raising additional capital in future. That it is advisable to
issue equity and preference shares in developing an optimum capital structure. Debentures and
bonds should be reserved for futures financial requirements.
2. Minimum Cost A sound capital structure attempts to establish the security-mix in such a way as
to raise the requisite funds at the lowest possible cost. As the cost of various sources of capital is
not equal in all circumstances it is ascertained on the basis of weighted average cost of capital. The
management aims at keeping the expenses of issue and fixed annual payments at a minimum in
order to maximize the return to equity shareholders.
3. Maximum Return A balanced capital structure is devised in such a way so as to maximize the
profits of the corporation through a proper policy of trading on equity so as to minimize the cost of
capital.
4. Minimum Risk An ideal capital structure possesses the quality of minimum risk. Risks, such as
increase in taxes, rates of interest, costs, etc., and decrease in prices and value of shares as well
as natural calamities adversely affect the companys earning. Therefore, the capital structure
devised in such a way as to enable it to afford the burden of these risks easily.
5. Maximum Control A sound capital structure retains the ultimate control of a company with the
equality shareholders who have the right to elect directors. Due consideration is given to the
question of control in management while deciding the issue of securities. The existing shareholders
may not be able to retain control. If a large number of equity share are issued, the company issues
preference shares or debentures instead of equity shares to the public because preference shares
carry limited voting rights and debentures do not have any voting rights. The capital structure of a
company is changed in such a way which would favorably affect the voting structure of the existing
shareholders and increase their control on the companys affairs.
6. Flexible A flexible capital structure enables the company to make the necessary changes in it
according to the changing conditions and make it possible to procure more capital whenever
required or redeem the surplus capital.
7. Liquid In order to achieve proper liquidity for the solvency of a corporation, all such debts are
avoided which threaten the solvency of the company. A proper balance between fixed assets and
current assets is maintained according to the nature and size of business.

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8. Conservative In division of the capital structure a company follows the policy of conservation. It
helps in maintaining the debt capacity of the company even in unfavourable circumstances.
9. Balanced Capital A balance is necessary for the optimum capital structure of a company. As
both, under capitalization and over-capitalization are injurious to the financial interests of a
company, there is a proper co-ordination between the quantum of capital and the financial needs of
the corporation. A fair capitalization enables a company to make full utilization of the available
capital at minimum cost.
10. Balance Leverage - A sound capital structure attempts to secure a balanced leverage by issuing
both types of securities i.e., ownership securities and creditor ship securities. Shares are issued
when the rate of capitalization is high, while debentures are issued when rate of interest is low.
IMPORTANCE OF SOUND CAPITAL STRUCTURE
1. Minimized Cost The primary objective of a company is to maximize the shareholders wealth
through minimization of cost. A well-advised capital structure enables a company to raise the
requisite funds from various sources at the lowest possible cost in terms of market rate of interest,
earning rate expected by prospective investors, expense of issue etc. this maximize the return to
the equity shareholders as well as the market value of shares held by them.
2. Maximized Return The primary objective of every corporation is to promote the shareholders
interest. A balanced capital structure enables company to provide maximum return to the equity
shareholders of the company by raising the requesting capital funds at the minimum cost.
3. Minimize Risks A sound capital structure serves as an insurance against various business risks,
such as interest in costs, interest rates, taxes and reduction in prices. These risks are minimized by
making suitable adjustments in the components of capital structure. A balanced capital structure
enables the company to meet the business risks by employing its retained earning for the smooth
business operations.
4. Controlled Though the management of a company is apparently in the hands of the directors,
indirectly, a company is controlled by equity shareholders carry limited voting rights and debentures
holders do not have any voting right, a well-devised capital structure ensures the retention of
control over the affairs of the company with in the hands of the existing equity shareholders by
maintaining a proper balance between voting right and non-moving right capital.
5. Liquid - An object of a balanced capital structure is to maintain proper liquidity which is necessary
for the solvency of the company. A sound capital structure enables a company to maintain a proper
balance between fixed and liquid assets and avoid the various financial and managerial difficulties.
6. Optimum Utilization Optimum utilization of the available financial resources is an important
objective of a balanced financial structure. An ideal financial structure enables the company to
make full utilization of available capital by establishing a proper co-ordination between the quantum
of capital and the financial requirements of the business. A balanced capital structure helps a
company to estimate both the states of overcapitalization and under-capitalization which are
harmful to financial interests of the company.
7. Simple A balanced capital structure is aimed at limiting the number of issues and types of
securities, thus, making the capital structure as simple as possible.
8. Flexible Flexibility or capital structure enables the company to raise additional capital at the time
of need, or redeem the surplus capital. it not only helps is fuller utilization of the available capital but
also eliminates the two undesirable states of over-capitalization and under capitalization.

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FACTORS DETERMINING CAPITAL STRUCTURE

The factors determining capital structure of a company may be internal or external.
A. INTERNAL FACTORS
1. Nature of Business Companies have stable earnings can afford to raise funds through sources
involving fixed charges, while other companies have to rely heavily in equity share capital. Public
utilities, extractive, financing and merchandising enterprises are more stable in their earnings and
enjoy greater degree of freedom form competition than industrial concerns.
2. Regularity of Income Capital structure is affected by the regularity of income. If a company
expects regular income in future, debenture and bonds should be issued. Preference shares may
be issued if a company does not expect regular income but it is hopeful that its average earnings
for a few years may be equal to or in excess of the amount of dividend to be paid on such
preference shares.
3. Certainty of Income If a company is not certain about any regular income in future, it should
never issue any type of securities other than equity shares.
4. Desire to control the Business If the control of the company is to be retained within few hands,
a large proportion of funds is raised by issuance of non-voting right securities, such as debentures
and preference shares. A majority of voting right securities, i.e. equity shares are held by the
promoters or their relatives to control the affairs of the business. Thus, majority of funds are raised
from public retaining the control of the company with the promoters or the existing shareholders.
5. Development and Expansion Plans Capital structure of a company is affected by its
development and expansion progremmes in future. The amount of authorized capital is kept higher
so that the requisite amount may be raised at the time of need. In the beginning the company
collects capital by issuing shares. Therefore, capital structure is devised in accordance with the
future development and expansion programmes. The requisite capital is raised through preference
shares and debentures.
6. Purpose of Finance An important factor determining the type of capital to be raised is the
purpose for which it is required. If funds are needed for some product give activity directly adding to
the profitability of the company, capital may be raised by issuing securities bearing fixed charges
like preference shares and debentures. On the other hand, if funds are needed for such purposes
as betterment, maintenance, etc. which do not directly add to the earnings of the company retained
earnings, equity share capital will be the better source of financing.
7. Characteristic of Management Varying in skill, judgement, experience, temperament and
motivation management evaluates the same risks differently and its willingness to employ debt
capital also differ. Thus capital structure is influenced by the age, experience, ambition, confidence,
conservativeness and attitude of the management.
8. Trading on Equity Trading on equity means the regular use of borrowed capital as well as equity
capital in the conduct of a companies business. If a company employ borrowed capital including
preference share capital to increase the rate of return on equity shares, it is said to be trading on
equity. If the fixed rate of interest on borrowed capital or dividend on preference shares is lower
than the general rate of earnings of the company, the equity shareholders will have an advantage in
the form of additional dividend. Trading on equity implies the presence of a favourable financial

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leverage in the companys capital structure. A company would prefer to issue debentures or
preference shares having a rate of interest or dividend lower than the general rate of its earnings.
9. Debt capacity and Risk After a certain extent the use of borrowed capital become risky for the
company because it leads to increase in the fixed liability of interest payment adversely affecting
the companys income and reducing its liquidity. Excessive use of borrowed funds endangers the
solvency of the company in the long run. High debt equity ratio is particularly risky for the
companies with uncertain, irregular and inadequate earnings. The determination of debt equity ratio
of such companies should be in accordance with their debt capacity.
10. Cost of Capital Cost of capital is an important determinant of capital structure of a company. It
influences the profitability and general rate of earnings. A company must raise capital funds by
borrowing when rate of interest is low, and by issuing equity shares when rate of earnings and
share prices are high.
11. Capital Gearing Ratio The ratio of equity share capital to the total capital is called Capital
Gearing. When the ratio of equity shares is low in the total capital structure, is called High
Gearing. On the contrary when the ratio of equity shares in the total capital structure of a company
is high, it is called Low Gearing. Stability in equity price and goodwill of a company depends on
adequate capital gearing. A high capital gearing ratio encourages speculation in shares of such a
company and market price of shares continuous to fluctuate. Therefore, it is necessary for the
promoters to determine the ratio of fixed cost securities (preference shares and debentures) and
fluctuating cost securities (equity shares) very carefully.
12. Flexibility The capital structure must have flexibility as to increase or decrease the funds as per
requirements of the enterprise. Excessive dependence on fixed cost securities make the capital
structure rigid due to fixed payment of interest or dividend. These sources should be kept in reserve
for emergency and expansion purpose.
13. Simplicity The capital structure must have simplicity, so that financial crises may be avoided.
B. External Factors

1. Tastes and Preference of Investors An ideal capital structure is one which suits the needs
of different types of customers. Its success largely depends upon the psychological conditions
of different types of investors. While some investors prefer security of investment and stability of
income others prefer higher income and capital appreciation. Hence, shares and debentures
should be issued in accordance with the tastes and preferences of all types of customers. To
suit the financial status of various sections of the society, a company should issues different
types of securities with different denominations.

2. Conditions of Capital Market Conditions of capital market have a direct bearing on the
capital structure. In times of depression the possibilities of profit are the least and rate of
dividend on equity shares comes down. Hence the investors would prefer to invest in
debentures and not in equity shares. Therefore debentures should be issued in times of
depression. On the contrary, any type of security can be issued to raise the requisite funds
during boom period when people have sufficient funds. Therefore, equity shares should be
issued during boom period.

3. Cost of Capital As the cost of capital issue affects the capital structure of a company. The
capital structure should be designed to minimize the commission payable to brokers,
middlemen and underwriters or the discount payable on issue of debentures and bonds. A

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company should raise funds by issuing different types of securities in such a way as would
minimize the cost of capital issue.

4. Present Statutes and Rules Capital structure a influenced by the statures and rules
prevailing in the country. In India, Banking Companies act restricts a banking company from
issuing any type of securities other than equity shares. Control of capital issues Act has fixed 4 :
1 ratio for debt and equity and 3:1 ratio for equity and preference share capital.

5. Possible Changes in Law Besides complying the legal restrictions, a companys capital
structure is also influenced by the possible changes in the law of the country. For example, if a
companys income is taxed at a higher rate then the directors should issue debentures because
the amount of interest payable to debentures holder is deducted while computing the companys
total income. Whereas it is a statutory deduction, dividends are not an accepted deduction.
CONCEPT OF BALANCED CAPITAL STRUCTURE
Capital structure or financial plan refers to the composition of long-term sources of funds as debentures,
long-term debts, preference and ordinary share capital and retained earnings (reserves and surpluses).
Companies that do not plan their capital structure may prosper in the short run, but ultimately they face
serious problems in raising funds to finance their activities. Therefore, it is important for a company to take
a decision regarding its capital structure. Whenever financial manger considers the question of capital
structure, it is always the question of optimum or balanced capital structure i.e., to decide the proportion of
ownership funds and borrowed funds. Ownership funds include ordinary and performance share capital
and retained earnings (reserves and surplus) while borrowed funds include the amount raised by the issue
of debentures, and loans taken from the financial institutions.
Optimum or balanced capital structures means an ideal combination of borrowed and owned capital that
may attain the marginal goal i.e. maximizing of market value per share of minimization of cost of capital.
the market value is maximized or the cost of capital is minimized when the real cost of each source of
funds is the same. It is the task of the financial manages to determine the combination of the various
sources of long-term finance.
CHARACTERISTICS OF A BALANCED CAPITAL STRUCTURE
A sound capital structure should be devised keeping in view the interests of the ordinary shareholders,
employees, customers, creditors etc. A sound capital structure should possess the following
characteristics.
1. Profitable The capital structure should be devised in such a way as to maximize the profits of the
company keeping in views the burden of the cost of capital on the income of the firm. In order to
achieve this objective, a proper policy of trading on equity should be followed.
2. Solvent Due consideration should be given to the solvency of the company. If a debt threatens
the solvency of the company, it should be avoided.
3. Flexible The capital structure of a company should be flexible enough to suit the changed
conditions. The company should not feel any difficulty in raising funds when they are required or in
redeeming them when they are not required nay more. Equity shares score over preference shares
because there is greater liberty in the payment of dividends on equity shares. Similarly preference
shares are preferred to debenture as non-payment of interest on debentures. Likewise, debentures
can be reduced at any time even before maturity under terms of issue. The redemption of
preference shares does not affect the nature but composition. The ordinary shares cannot be

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redeemed except under the scheme of re-organization. Considering this fact, the capital structure
should be as flexible as possible.
4. Conservative A company should follow the policy of conservation while devising its capital
structure in the sense that the debts capacity of the company should not be disturbed. The
management should bear in mind the various factors and their effects on its creditability such as
value of other securities, issue of securities in future maintenance of profits, burden of taxes and
future rearrangement of capital structure etc. such capital structure offers certain decisive
advantages to the company, namely, (i) the companys cost of capital is the least; (ii) its prospects
of raising capital are good in future even in unfavorable times; and (iii) it can be successful in
maintain healthy relations with security holders. This policy favors for the maintenance of Reserve
and surplus at a fairly high figure in a bid to provide guarantee to contributors of funs towards debt
paying capacity of the company.
5. Controlled Sound capital structure provides maximum control of the equity shareholders on the
companys affairs.
6. Simplicity A sound capital structure defines clearly the rights attached to each type of securities.
It is easy type of securities. It is easy to manage.
7. Economic Capital mix entails the minimum cost of issue of securities and cost of financing etc.
8. Attractive Securities proposed to be issued offer certain attractions to the investors either in
relation to income, control or overtability.
9. Balanced in Leverage Both types of securities i.e., ownership and creditor ship, are issued to
secure a balanced leverage. Normally, debentures are issued when rate of interest is low and
shares when rate of capitalization is higher.

OBJECTIVES OF BALANCED CAPITAL STRUCTURE

In devising a sound or balanced capital structure, the manager should bear in mind the following
objectives.
A. ECONOMIC OBJECTIVES
1. Minimum Costs Central cost of various sources of funds are not equal in all circumstances. One
of the major objectives of a business enterprise is to raise funds at the lowest possible cost in a
given set of circumstances in terms of interest, dividend and the relationship of earnings to the
prices of shares. The management should aim at keeping the cost of issue at a minimum to
maximum the returns to equity shareholders.
2. Minimum Risks Various risks are involved in business operations which have direct bearings on
the capital structure of the company such as business risk, management risks, tax risk, trade cycle
risks, purchasing power risks, interest rate risk etc. These risks should be minimized by making
suitable adjustments in the components of capital structure.
3. Maximum Return On of the objectives of balanced capital structure is to provide for the
maximum return to the real owners (equity shareholders) of the company. It may be achieved by
minimizing the cost of issue and the cost of financing.
4. Preservation of Control of Equity Shareholders Generally equity shareholders have the
control over the affairs of the company. Preference shareholders and the debenture holders have
limited voting rights in matters affecting their interests. The capital structure should be designed as

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to preserve the control of equity shareholders and to prevent the erosion of control from their
hands. It requires proper balance between voting right and non-voting right capital.
5. Proper Liquidity Liquidity is necessary for the solvency of the company. A proper balance
between fixed assets and the liquid assets should be maintained. Nature and size of the business
decide the ideal ratio of fixed and liquid assets.
6. Fuller Utilization There must be proper co-ordination between the quantum of capital and the
financial requirements of the business so that full utilization of available capital may be made at
minimum cost. Both the states of under capitalization and unwarranted to the health of industry.
Fuller utilization of capital is also not possible in case of watered capital. Full utilization of capital
requires a fair capitalization.

B. OTHER OBJECTIVES

1. Simplicity The capital structure should be as simple and conservative as possible. In the
beginning a company should raise only the ownership capital i.e., equity share capital that will
enhance the credit of the company. A preference issue may be made if, warranted by the
circumstances.

2. Flexibility The management should design the capital structure in order to make necessary
changes in it whenever required. Management should enjoy the maximum freedom of action to
manage the income and capital of the firm.

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UNIT VI
SOURCES OF FINANCE I
CORPORATE SHARE CAPITAL
A company needs finance to meet its various types of requirements. While some fund are required for a
fairly long time for the purpose of acquiring fixed assets, some other are required for day today working.
The method of raising funds is decided after taking into consideration the period for which funds are
required. Long-term funds are raised in such way that a company may have uninterrupted use of it for a
sufficiently long time. It is unwise for a company to take loans from a bank to acquire a fixed asset as loan
as it is a source of obtaining funds only for a short period.
Source fork funds for a company may be classified into two broad categories according to he mode of
raising funds (1) By issue of securities such as shares (equity and preference) and debentures and (2) By
other methods such as financial institutions etc. According to the Indian Companies Act 1956, a company
can issue two types of securities (1) ownership securities, and (2) creditor ship securities. The ownership
securities include the equity and the performance shares, while creditor-ship securities include debentures
and bends.

1. Ownership Securities These may be classified into (i) equity shares and (ii) preference shares.
(i)

Equity Shares These are the shares the holders of which are the residual climates and
have no preference in capital as well a in the income of the company. They provide the risk
capital or venture capital of the company. They control the affair of the company and carry
with them the ownership responsibilities.

(ii)

Preference shares Section 85(I) of the Companies Act, has defined preference shares as
those which carry preferential rights about the payment of dividend at a fixed rate either
free of or subject to income tax, and about the repayment of capital. these shareholders
enjoy two preferential rights over the other category of shares. Firstly, they are entailed to
receive a fixed rate of dividend out of the net profits of the company prior to declaration of
dividend on equity shares. Secondly, after the payment of debts of the company under
liquidation, the remaining assets are first appropriate for returning the capital contributed by
the preference shareholders.

2. Creditorship Securities
(i)

Debentures A debenture is an acknowledgement of debt by a company under its seal.

Debentures are equal parts of a loan raised by a company, offered to the public through
prospectus. Debentures always secured either by floating charge or by fixed charge.

(ii)

Bonds Bond is an agreement between bond holders and the company, called bond-indenture
containing the terms and conditions. Appointed by the company, a trustee acts as an agent of
the bondholders. Bonds may be classified as secured and unsecured, redeemable and
irredeemable bonds etc. A big majority of bonds carry a fixed rate interest.

SIGNIFICANCE OF SECURITIES IN FINANCIAL STRUCTURES

Following is the significance of securities in the financial structure of a company:
1. Bonds or debentures are issued only when the future earnings of company are liberal and fairly
consent. A public utility concern may collect a fairly large amount through debentures as its earning
are somewhat constant.

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2. Equity shares are issued and debt is contracted in the beginning by basic and manufacturing
industries.
3. Only equity shares are issued when fresh capital required by an existing concern whose previous
earnings have been unstable.
4. Cheap borrowed funds are used for expansion purposes, when a company has become well
established and the earning have stabilized. When debentures are issued to obtain these funds, it
is twice the interest charges being carried by the public utility concerns and four times by other
concern.
5. If funds are obtained on the basis of mortgage issue, the total amount thus collected does not
exceed half the depreciated value of the assets covered by the mortgage.
6. Industrial having large assets may issue irredeemable debenture or long-term redeemable
debentures.
7. When the earnings are irregular but average profits over a period of years give a fair margin over
preference shares, dividend preference shares may be issued.
MEANING OF SHARE CAPITAL
Share capital is the capital raised by a company through the issue of shares. It constitutes the basis of the
capital structure of a company. Only companies limited by shares and registered with a share capital can
raise capital through the issue of shares. Share capital may be raised either at the time of formation of the
company for starting business operations or, later on for future expansion of the business. Authorized
capital is the sum mentioned in the Memorandum of Association as he capital of the company. It is the
maximum amount of capital which the company is authorized to raise by the issue of shares. Issued capital
is the part of the authorized capital which is issued for public subscription for the time being.
MEANING OF SHARE
1. Share means share in the share capital of company and includes stock where a distinction
between stock and shares is expressed or implied.
-Section 2 of the Indian Companies Act 1956
2. A share is that proportionate part of capital to which a member is entitled.
-

Lord Justice James Lindley

The total capital of the company is divided into a large number of shares to facilitate public subscription to
the capital in smaller amount. For example if the capital of a company is Rs. 20,00,000, it can be divided
into 200,000 shares of Rs. 10/- each. Thus share is one of the equal parts into which the capital of a
company is divided entitling the holder of the share to a proportion of the profits.
KINDS OF SHARES
According to the Indian Companies Act 1956, following are two types of shars:
(i)

Equity Shares

(ii)

Preference Shares

(i)

Equity Shares Equity means the ownership interest or the interest of shareholders as
measured by capital and reserves. According to the Indian Companies Act 1956 equity shares
are those ownership securities which do not carry any special or preferential rights in respect of

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dividend or return of capital. equity shareholders are the owners and risk-bearers of the
company. An equity shares is distinguished by the following characteristics.

a. No fixed rate of dividend Dividends in respect of equity shares are paid only after the
preference shareholders have been paid the dividends due to them.

b. Payment after Debt. Repayment In the case of winding up of the company, an equity
shareholder will be paid back his capital only after all other debts, including the preference
share capital, has been repaid in full.

c. Right to Vote The equity shareholders is entitled to the rights to vote at the annual
general meetings of the company. He participates in the management and control of the
company. The right is not available to the preference shareholder except in special
circumstances.
(ii)

Preference Shares According to Indian Companies Act 1956 A preference share is a share
which carries a preferential right both as regards to a fixed dividend and as regards to the
payment of capital in winding-up.
The preference shares have the following characteristics
1. There is a fixed rate of dividend to them.
2. They get priority over equity shareholders in respect of payment of dividend.
3. They are paid back their capital ahead of equity shareholders in the event of the companys
liquidations.
4. They do not have any voting rights except in some special circumstances.
5. Preference shares stand mid-way between debentures and equity shares. Like debentures
they get a fixed dividend and enjoy priority over equity shareholders in the payment of
dividend as also return of capital return of capital in the case of winding up. Like debentures
they do not enjoy any voting rights. On the other hand, like equity shares they participate in
the residual profits of the company.
6. Preference shareholders are paid dividend, not interest, though dividend on such shares is
paid at fixed rate.
7. There is no legal obligation to pay dividend on such shares year after year. If the company
does not have enough profits in any year it can avoid payment of dividend on preferences
shares without inviting any legal action.

TYPES OF PREFERENCE SHARES

A according to the rights attached to them the preference share may be of the following types:
1. Cumulative and Non-Cumulative Preference Shares
2. Participating and Non-Participating Preference Shares
3. Redeemable and Irredeemable Preference Shares
4. Convertible and Non-convertible Preference Shares
5. Guaranteed Preference Shares.

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1. Cumulative and Non-Cumulative Preference Shares The holders of cumulative preference

shares are entitled to arrears of dividend on their shares to be paid out of the profits of subsequent
years, if the dividend on them cannot be paid in any year. They are sure to receive dividend on the
preference shares held by them for all the years out of the earnings of the company. If they are not
paid the dividend in a particular year, they are paid such arrear in the next year before any dividend
can be distributed among equity shareholders but if dividend is not paid in any year the dividend on
non-cumulative shares does not accumulate.
2. Participating and Non-Participating Preference Shares The holders of participating preference
shares are entitled to a shares in the surplus profits after paying dividend to preference shares and
equity shares. Thus, participating shareholders obtain return on their investment in two forms fixed
dividend and shares in surplus profits. Non-participating preference shares are those preference
shares which do not carry the right to share in the surplus profits.
3. Redeemable and Irredeemable Preference Shares Redeemable preference shares are those
which will be repaid on or after a certain date in accordance with the terms of their issues.
Irredeemable preference shares are those preference shares which cannot be redeemed during the
life time of the company.
4. Convertible and Non-Convertible Preference Shares Convertible preference shares are those
preference shares which are given a right to be converted into equity shares within a fixed period of
time. Non-convertible preference shares are the preference shares which cannot be converted into
equity shares.
5. Guaranteed Preference Shares These shares are issued when a company is converted from a
private limited to Public United company or when one company is sold to another company. The
seller or any other interested party guarantee the payment of dividend on preference shares of a
specific rate for a number of years.

MERITS OF PREFERENCES SHARES

1. ADVANTAGES FROM COMPANY POINT OF VIEW
(i)

Fixed Return The dividend payable on preference share is usually fixed lower than that
payable on equity shares. This helps the company in maximizing the return to equity
shareholders.

(ii)

No voting Right Preference shareholders have no voting right on matters not directly
affecting their rights, leaving equity shareholders ration uninterrupted control over the affairs
of the company.

(iii)

Flexibility By issuing redeemable preference shares a company can maintain flexibility in

its capital structure as these can be redeemed under terms of issue.

(iv)

No Burden on Finance Unlike debentures or bonds, preference shares do not prove a

burden on the finances of the company. Dividend on preference shares are paid only if
profits are available for it. Thus the company has a stronger balance sheet and hence
greater scope for future borrowing.

(v)

No charge on Asset Non payment of dividend on preference share does not create a
charge on the assets of the company. It enables the company to conserve mortgage able
assets of the company. It is therefore very useful if its assets are made available as
collateral security for borrowing on debentures.

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(vi)

Wide Capital Market The issue of preference shares widens the scope of capital market
as they provide the safety as well as a fixed rate of return to the investors. The company will
not be able to attract the capital from such moderate type of investors if it does not issue
preferences shares.

2. ADVANTAGES FROM INVESTORS POINT OF VIEW

(i)

Regular Fixed Income Even if there is no profit,. The investors get a fixed and regular rate of
dividend on preference shares. The dividend for the years in which company earned no profit or
inadequate profits, may be paid in the year of profits.

(ii)

Preferential Rights In case of winding up of company, preference shares carry preferential

rights as regards the payment of dividend and repayment of capital. thus they enjoy the
minimum risk.

(iii)

Voting Right for Safety of Interest In matters directly affecting their interest preference
shareholders re given voting rights. Thus their interest is safeguarded.

(iv)

Lesser Capital Losses As the preference shareholders are given voting rights in saves them
from capital losses. Their interest is safeguarded.

(v)

Fair Security During depression period when the profits of the company goes down or when
the rate of interest in the market continuously falls down, preference shares are fair securities
for the shareholders.

1. Demerits for investors

(i)

No voting Right The preference shareholders enjoy no voting right except in matters directly
affecting their interest. Hence, they do participate in policy decisions.

(ii)

Fixed Income Even if the company earns higher profit, the dividend on preference shares
other than participating preference shares is fixed.

(iii)

No claim over Surplus The preferential shareholders have no claim over the surplus. They
may only ask for the return of their capital investment in the preference shares of the company.

(iv)

Redemption A company may redeem the redeemable preference shares at its option at any
time when it feels convenient to pay them off.

(v)

No Guarantee of Assets A company provides no security to the preference capital as is

made in the case of debentures. Thus their interests are no protected by the assets of the
company.

EQUITY SHARES
Equity Shares are those which constitute working capital of a company. Dividend on these shares is not
fixed. It is paid after the fixed rate of dividend on preference shares has been paid off. Even on dissolution,
they are residual climate. However, with voting right they control the affairs of the company.
1. MERITS OF EQUITY SHARES
(i)

Long term and permanent Capital Equity is a good sources of long-term finance. During
its life-time a company is not required to pay-back the equity capital. Thus, it is a permanent
sources of capital.

(ii)

No fixed Burden Equity shares impose no fixed burden on the company resources, as the
dividend on these shares is subject to availability of profits and the intention of the Board of

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Directors. Shareholders may not get the dividend even if the company has profits. They may
get the dividend out of accumulated profits even if the company has earned no profit or
inadequate profits for the current year. Thus equity shares provide a cushion of safety against
unfavorable development.
(iii)

Credit Worthiness Insurance of equity share capital cerates no charge on the assets of the
company. A company may raise further finance on he security of its fixed assets. Equity capital
provides safety to the creditors.

(iv)

Risk Capital Equity capital is the risk capital. A company may trade on equity in bad periods.
If the company earns lesser profits by trading on equity the equity shareholders would be the
real loser.

(v)

Dividend Policy A company may follow an elastic and rational dividend policy creating huge
reserves for its development programmes.

2. MERITS TO INVESTORS
(i)

More Income After meeting all the fixed commitments i.e. interest on debentures and
preference shares equity shareholders are the residual claimant of the profits. To add to its
profits the company generally trade on equity. In boom period equity may get dividend at a
higher rate.

(ii)

Right to Participate in the Control and Management Equity shareholders have voting rights
on control over the affairs of the company. They elect competent persons as directors on the
Board of Directors to control and manage the affairs of the company.

(iii)

Capital Appreciation The market value of equity share fluctuates directly with the profits of
the company. Their real value is based on the net worth of the companys assets. It brings
capital appreciation in their investments. If the profits of the company are accumulated, it will be
distributed among the shareholders as bonus shares, thus increasing the capital.

(iv)

Attraction for Persons having Limited Income As equity are mostly of lower denomination,
persons of limited resources can purchase these shares. This widens the scope of
marketabilitys of these shares.

(v)

Pre-emptive Right In any successive issue of shares of the company the equity shareholders
of a company have pre-emptive right in a certain proportion fixed by the Boards of Directors.
The equity shareholders may be benefited by such right issue, if the company is a prospecting
company.

(vi)

Other Advantages Their prices in security market are more fluctuating as it appeals most to
the speculators.

1. DEMERITS OF EQUITY SHARES

(i)

Dilution in Control Each sale of equity shares dilutes the voting power of the exiting equity
shareholders, as it extends the voting or controlling power to the new shareholders. As equity
shares are transferable certain groups of equity shareholders may manipulate control and
management of company by controlling the majority holdings which may be detrimental to the
interest of he company.

(ii)

Trading on Equity not Possible A company cannot trade on equity if equity shares alone are
issued. Trading on equity is possible only when the other securities, bearing fixed rate of

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dividend/interest are issued and the dividend or interest payable such securities is less than the
profitability rate of company earnings.
(iii)

Over Capitalization Excessive issue of equity shares may result in over-capitalization which
makes dividend per share low which adversely affects the psychology of the investors.

(iv)

Inflexibility of Capital Structure Equity shares cannot be paid back during the life-time of the
company, it creates inflexibility in its capital structure. High costs more to with equity shares
than with other securities settling costs and underwriting commission are paid at a higher rate
on the is one of these shares.

(v)

Speculation Equity shares of good companies are subject to hectic speculation in the stock
market, making prices fluctuate frequently, which is not in the nearest of the company.

2. DEMERITS TO COMPANY

(i)

Uncertain and Irregular Income The payment of dividend on equity share is subject to the
availability of profits and the intention of the Board of Directors. As the income of any
commercial organization is not regular and certain, the equity shareholders may not get any
dividend if there is insufficient profit or if the management thinks it proper not to pay any
dividend on these hares even if there are sufficient profits.

(ii)

Capital Loss During Depression Period During depression period the profits of the
company and consequently the rate of dividend comes down due to which the market value of
equity shares goes down resulting in a capital loss to the investors.

(iii)

Loss on Liquidation Equity shareholders are the worst sufferers in case of liquidation of the
company because they are paid in the last after every other claim including the claim of
preference share holders is settled.

SHARE
1. Share is Share in the share capital of a company and includes stock, except where a distinction
between stock and share is expressed or implied.
-

Section 2(46) of the Indian Companies Act 1956

2. A share may be defined as the interest of a shareholder in the company measured by a sum of
money, for the purpose of liability in the first place and of interest in the second, and also consists of
a series of mutual convenient entered into by all the shareholders inter-se in accordance with the
provisions of companies act and Articles of association.
-

Justice Farwell

STOCK
Stock is the aggregate of fully-paid up shares of a company consolidated for the purpose of facilitating its
division into factions of any denomination. Authorized by its Articles of Association a company with a sharecapital may convert some or all of its fully paid-up shares into stock. When so converted, stock represents
the consolidated amount of the capital of the company. It may be split-up or transferred in fractions of any
denomination, without regard to the original face value of the shares. Such fractions bear no distinctive
numbers, but only represent specified parts of the consolidated capital. a stockholder may transfer any
fraction of the stock held by him.

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DIFFERENCE BETWEEN SHARE AND STOCK

1. Difference in Paid-up Amount - While a share may be partly paid up or fully paid up, a stock is
always fully paid up. Only fully paid up shares can be converted in to stock.

2. Difference in Nominal Value While a share has a nominal value, a stock has no nominal value.
3. Difference in Transferability in Fractions While shares cannot be transferred in fractions a
stock can be transferred to any fraction and sub-division.

4. Difference in Distinct Numbers While all shares bear distinct numbers representing the units of
share capital, stocks disclose the consolidated value of the share capital. Fractions of stock do not
any number.

5. Difference in Denomination While all shares are of equal denomination, stock may be of
unequal amounts and may be transferred in different fragments.

6. Difference in Offer to Public While shares may be issued to the public directly in the first
instance, stocks cannot be offered directly to the public. Only fully paid up shares are converted into
stock.

7. Difference in Registration While shares are always registered and nor transferable by delivery,
stocks may be registered and transferred only by delivery.
DEFERRED SHARES
Public companies in India are not permitted to issue deferred shares. But in many other countries such
shares are issued by companies. in India, these can be issued by independent private companies. deferred
shares are issued subject to the condition that their holders will rank last of all in the matter of dividend
payment. The shareholders may not receive any dividend at all if the company makes a small profit.
However, if the company earns huge profits, they are entitled to receive even higher dividends that the
preference and equity shareholders. Thus deferred shareholders are often paid a high rate of dividend out
of the balance of profits left after payment of a dividend at a fixed rate to preference shareholders and at a
reasonable high rate to equity shareholders. On account of the deferred claim on dividend the public are
not attract to these shares. They receive some compensation for their services by way of high dividend
which they enjoy in prosperous year. Hence deferred shares are also known as founders shares. These
shares are also issued to underwriters.
DISTINCTION BETWEEN DEFERRED AND EQUITY SHARES

1. Profits Deferred shareholders are entitled to share in the redual profits of the company only after
the rights of the performance and equity shareholders have been satisfied.

2. Liquidation If the company goes into liquidation, the deferred shareholders may get refund of
capital and participate in the surplus capital, if any, after the rights to preference and equity
shareholders have been satisfied.

3. Right of Priority Deferred shareholders do not enjoy the right of priority to have shares offered in
case of further issue of shares by the company.

4. Transferability Deferred shares are not freely transferable.

NO-PAR STOCK

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The no-par shares issued in the U.K., the U.S.A. and Canada are gaining popularity day to day. Such
shares are not issued in India.
No-par stock means share having no face value. the total owned capital of the company is dividend into a
certain number of shares. Share certificate only states the number of shares held by a particular holder
without mentioning the face value of shares. The value of share can be calculated by dividing the total
owned capital (real network) with the number of shares. Thus the question of difference between nominal
value and market price of shares does not arise. It is meaning less to issue shares at premium or at
discount. Dividend is paid by way of a given amount per share instead of certain percentage of the fixed
nominal value of shares.
MERITS OF NO-PAR STOCK
1. True and correct Position in the Balance Stock In no par stock the balance sheet shows a true
and correct position of the business as there is no need for inflating the assets to offset inflated or
watered stock issues. The capital is always equal to the net worth and not an imaginary amount as
with shares of nominal values.
2. Real value of Holdings In no-par stock as value of shares is related to the earnings, the
shareholders know the real value of their holdings which is always determined on the basis of net
assets of the company.
3. Easy Marketing of Shares Issue of no-par shares avoids many legal formalities because the
questions of their issue at premium or at discount does not arise as there is not par-value of such
shares. This market marketing of such shares very easily.
4. No Reduction of Capital In no-par stock as the value of shares is automatically adjusted with the
earning capacity, there is no question of reduction of capital at the time of reconstruction and
reorganization of companies.
5. No Future Calls In no-par stock as the whole of the amount is collected in one sum at the time of
issue of shares the shareholders have no liability beyond the initial payment.
6. Freedom No par stock gives a complete freedom for fixing the price in the market that
commensurate with the prevailing conditions in the market and provides relief from the rigid legal
requirements. While at the initial stage a company can issue the shares at low prices its later
achievements may make possible the subsequent issues at higher prices.
7. No manipulation of Accounts A company issuing no par stock need not manipulate its
accounts. It has no motive to conceal the stock discount, underwriting commission and other costs
as these can be deducted from the sales proceeds of the shares.
8. Correction to over Capitalization As there is no face value, directors have every right to adjust
the value of capital to correct the over capitalization.
9. Careful Financial Study As the real value of shares depends very much on the earning capacity
of the company, it induces the investor to study the financial position of the company carefully.
DEMERITS OF NO PAR STOCK
1. No Standard of Valuation No par shares have no standard on the basis of which valuation of
assets may be compared with capitalization. Because the priced level is deceptive, the ignorant
investors may be decided. Investors cannot make valuation of their stock. In the absence of par
value, they cannot judge the fairness of return.

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2. Manipulation of sales and dividend It offers enough scope to management to manipulate the
sale proceeds of shares and pay dividend out of capital. in the absence of any standard, the
management split the sale proceeds of stock into two or more parts. A nominal amount may be
credited to the stated paid up capital account and the balance to the capital surplus which may later
on be utilized for dividend.
3. Absence of Capital Planning There cannot be any planning for the financial need of the concern
which may lead the concern to over capitalization or under-capitalization.
4. Under-Payments to Promoters The flexibility of capital amount facilitates the promoters to pay
themselves unduly high remuneration for their services and for goodwill and concealing the losses.
5. No Security to Creditors The uncalled share capital provide an additional security to creditors
because it may be realized whenever necessary in case of par value shares. No par value share
provide no such security to creditors because the whole of the amount it called in one sum.
6. Balance Sheet Difficult in Understand No par value shares render the balance sheet of the
company unduly complex and difficult to be understood by investors, creditors and tax authorizes.
7. Facilitation of Tax Evasion If no par shares are issued, taxation becomes complicated and taxevasion is possible.
8. Difficult Calculation of Registration Fee The fee for the registration of companies is charged on
the amount of Authorized capital on par-value shares in almost all the counties of the world.
However, it is very difficult to calculate registration fee on companies issuing no par-value shares.
As the above limitations of the no par value shares have created certain doubts in the utility of the issue,
no-par shares have now lost their popularity even in the U.S.A.

TIMING OF ISSUES
The most noteworthy problem of securities is concerned with the selection of security to be issued to the
public according to prevailing capital market conditions. For example, suppose an existing company ahs
already issued 20,000 equity shares of Rs. 10/- each fully paid. The market value of its shares is Rs. 42/per share. Not the said company wants Rs. 4,00,000 as additional finance. The company should issue
equity shares for this finance. The company can issue only 20,000 equity shares @ Rs. 20/- each which
share only a 5% voting control, if the market value of existing shares is Rs. 8/- per share.

PRICING OF ISSUE
If shares are issued to the public they may be offered to them either at par, at a premium or at a discount.
The price at which a new issue of shares is offered to the markets is based mainly on the price and yields
on comparable issues already quoted. It is decided by the Board of Directors after negotiations with share
brokers, underwriters and stock exchange authorities etc. The offered price must also appear attractive to
the investing public and under-writers. It must be reasonable and commensurate with the risk involved and
write of control attached therewith.
If the Board of Directors decides to issue shares at par there is no problem. But if it wants to change a
premium, the investors must be attracted by a profit potential to purchase these shares at premium. The
companys management must take into account the market rating of similar companies in determining the
sale price of security. The strength of demand for new issues and the forecast of the level of maintainable
profits is also relevant. Also important is the capitalization factor i.e., P/E ratio (Price : Earning ratio) and

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the denomination of the security. Lower denominations such as Rs. 10/- per share are more appealing and
convenient than higher denominations securities.
IMPACT OF TRADE CYCLE
The total period of a trade cycle is divided into boom, recession, depression and recovery.
1. Boom In boom period, the trend in the market is upward, the demand of capital increases and
consequently the rate of interest goes up.
2. Recession Under recession, the demand of products is much less than the production. this
period is just reverse of boom period. The trend is downward. The demand of capital and the rate of
interest go down. As the investors prefer fixed income, the issue of preference shares or
debentures should be preferred.
3. Depression In depression period the market is pessimistic. Therefore, raising funds is quite
difficult. Only fixed income securities are preferred.
4. Recovery In Recovery period the upward trend starts and the demand of risk capital begins.
To conclude in the words of Gerstenberg. The best time to raise funds is when business is booming and
people are optimistic.

RIGHT FINANCING
If an existing company seeks to issue new series of equity shares to finance its additional activities, it
should offer these shares to the existing shareholders at a specified price during a particular period. This is
a right or Pre-emptive right which may be defined as an option to buy a security at the specified price,
generally at par or at premium but much below the market price. The shares offered are called Right
shares. Financing the projects of a company by the issue of such shares is right financing.
According to Section 81 of the Companies Act a company may increase its further capital by issue of new
shares at any time after the expiry of two years from the formation of the company limited by shares or of
one year after the first allotment of shares in that company, whichever is earlier. These new shares must
first be offered to the existing equity shareholders of the company in proportion, as nearly as
circumstances admit, to the capital paid upon those shares at the time of offer.

PROCEDURE OF RIGHT ISSUE

Following is the procedure of right issue according to the Companies Act:
Before making an offer to the existing shareholders the company will have to obtain the permission of
Controller of Capital Issus who takes decision on application for right issues in concurrence with the
company. Some conditions may be imposed on the company making an offer of rights. The company
sends a letter of offer to the existing equity shareholders whose name are on the Register of members
mentioning therein the number of shares to which they are entitled in proportion to their old share holding
and the time within which the offer must be accepted. This period shall no bless than 15 days from the date
of offer. However it may be more than 15 days because the shareholders must have sufficient time to make
up their mind judiciously. The offer must indicate that if it is not accepted within the specified period, it shall
be deemed to have been declined. It must also state that they have the right to renounce all or any of the
shares offered to them in favour of their nominee(s).

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The shareholder shall inform the company within stipulated period about his acceptance of right or the
name of the nominee to whom he wants to renounce his right. He may also apply for the additional shares.
But if he has renounced his right in favour of any person he is not entitled to apply for additional shares.
If the right shares are not fully subscribed, the balance left over shall be distributed equally among the
applicants for additional shares with reference to the shares held by them in the company. Preference shall
be allowed to small holders in concurrence with the stock exchange on which the companys share are
listed. The company may deal in any manner it likes with any balance left after making allotment of
additional shares.
VALUATION OF RIGHT SHARES
The right shares are issued by the company at par or at a premium but normally at less than the ruling
market price, so that shareholders may offer the right with a hope of some capital gain. The gain on shares
is the value of right which may be calculated in the following manner.
First, the market price of the existing shares is calculate added to it is the issue price of right shares. The
total of these two prices is averaged which is the value of right share. The difference between the maerkt
price and the average price is the value of right. For example, suppose a company makes right issue of
one share for every three shares held. The market value of existing share is Rs. 50 (for Rs. 10/- Share).
The issue price of right shares is Rs. 20 per share. (Face value Rs. 10/-)
The value of right shall be calculated as under:
The total market price of three existing shares
The issue price of right share

= 50 x 3 = Rs. 150

= 20

Total for 4 shares

= Rs. 170

Average Price per Share

= Rs. 170 / 4 = 42.50

Value of right (per share) = Rs. 50 (-) Rs. 42.50

= 7.50

MERITS OF RIGHT ISSUE

1. It Maintains Pro-rata Share Right issue give the existing shareholders an opportunity to maintain
their pro-rata share in the earning and surplus of the company and the voting power as before.
2. It increases goodwill The goodwill of the company increases in the eyes of existing
shareholders.
3. It lowers cost of issue The cost of issue of such shared will also be lower.
4. There is no botheration of selling The financial management is relieved of the botheration of
selling the shares.
5. It proves financial status If right shares are accepted by the shareholders enthusiastically, it
proves that financial position of the company is sufficiently good, and the company can obtain more
loans at lower rate of interest.

CONDITIONS OF PRICING THE RIGHT ISSUE

1. Amount the market can bear If the amount collected by issue of right shares is not invested in
securities yielding a good return or normal return, the market price of shares in the long run will go

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down. In that case, rights will not be used and investors will invest their funds in alternative
investment.
2. Market price of shares The company should keep vigil on the market price and see how it
shares have been moving in the market in the past and how these are likely to move, if the rights
are fixed at a particular price.
3. The general price trend in the capital market This mean the consideration whether the general
prices are stable or fluctuating. If the trend is not stable, the investors will not like to invest funds in
securities and rights cannot be favoured.
4. The profit earning capacity of shares If the shares have no capacity to earn profit, they will not
be accepted by the shareholder howsoever low their price may be. On the other hand, if profit
earning capacity of the shares are somewhat higher, regular and dependable, the rights will attract
the existing shareholders as well as their nominees even if rights are priced a bit hither.
5. The prospects of proposed plans of expansion If plans seem profitable, the right may be
priced a bit high. On the other hand, if the plans are not attractive or slow, the price will be fixed
differently.
6. Nature of Dividend policy If conservative policy of dividend is adopted by the company, the
shareholders shall not be interested in purchasing the rights. Here the price may be fixed much
lower. If the shareholders are getting good dividend the price may be fixed somewhat higher.
7. The resource position of the company If financial resource position of the company is sound,
the shareholders will be attractive to invest and the price may be fixed at somewhat higher level
otherwise the position will be reversed.
8. Fair return Whatever the pricing policy of rights, the enterprise should fix the premium, not so
low, nor so high. It should yield the shareholders a fair return. The enterprise should strike a
judicious balance between the two.

IMPACT OF RIGHTS OF FINANCE POLICY

Following is the impact of Rights on financial policy
1. Lower market price of shares As right shares are issued at a price much lower than the market
price of existing shares the market price is expected to fall to a considerable extent. This should be
considered by the company well in advance.
2. Spurt in Goodwill If the existing shareholders decline the offer the shares are offered to other
persons at the same price. If the company has a good record of payment of dividend, the
customers are tempted to purchase such shares at lower price even though, a decline in market
price is obvious, because they expect an increase in the market price of shares after a short spell
and if it is so, the goodwill of the company also goes up.
3. Lower Divided Right issue has an adverse effect on the market due to lower payment of
dividend. The dividend per share is lower due to increase in the number of share. It is on the
presumption that additional amount realized through the issue of rights will not be put to profit
immediately and it will take time in increasing the profits. Accordingly, even good shareholders
might feel disinclined to continue will the enterprise and begin to sell their holdings. Such a trend
affects the market adversely and the price of shares goes down. The company should ensures a
healthy balance between the use of amount invested and the income from the investment.

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4. Shareholders capacity to purchase shares If shares are fully subscribed by the shareholders,
the market is not very adversely affected. If the shareholders do not have capacity to purchase
shares, they either surrender their rights or renounce it in favour of their nominee. If the nominees
also surrender such shares thereby making these sharers available in the market and the market is
affected adversely. Under such circumstances it is better to offer right in lower propositions.
5. Fluctuation in the market price of the shares If the shares are favorably traded in the market,
without having any fluctuation in the price to a considerable degree, the rights will attract the
shareholders and the price may be fixed somewhat higher. But if the shares fluctuate, the issue will
diversely affect the market and the company will have to fix the price of the right share much lower.
6. Pre-offer pressure In respect of that particular share market comes under heavy pressure in preoffer period just after it is known to the public that the company is about to offer right shares. This
pre offer pressure is usually considerably great and the financial management should make every
effort to check that pressure otherwise its financial policy will be adversely affected.
7. Downward trend There are usually downward trends during the period of right issue. Even the
existing shares will come under heavy strains. If the financial management does not move swiftly,
its whole financial policy might come under unbearable heavy strains.

CORPORATE DEBT
A business firm obtain capital from the issue of ownership securities and by the issue of creditorship
securities. The amount collected by the issue of ownership securities is called owned capital. the amount
collected by the issue of creditorship securities is called debt capital. most of the business houses use debt
capital for financial requirements. It may be of three types depending upon its period of use i.e., short term,
medium-term and long-term. Examples of short term debts are trade creditors, bills payable, bank
overdraft, and creditors for expenses. Pubic deposits and other loans of periods ranging from three to five
year are medium term debts. Long term debts are obtained from specialized financial institution or by issue
of debentures and bonds to the public. Loans for which no security is issued are unfunded debts. Loans
against issue of security such as debentures or bonds are funded debts.
A company borrows capital in order to maximize the profits for its shareholders i.e., to pay higher dividend
to them. It continues to use this source of finance until the increment return is higher than the increment
cost of debt capital. if the percentage change in the earnings is higher than the percentage change in the
cost of capital, the company prefers debt-financing. In some exceptional cases, company accepts debt
capital at equilibrium point in which (cost of capital = estimated earnings). Thus, a company uses debt
capital to get the following advantages.
1. Retention of control As creditors are concerned only with the interest due on their debts. They
are not entitle to vote and participate in management of the concern. The control is retained by the
shareholders as before.
2. Trading on Equity It facilitates the company to trade on equity as the interest payable on debt
capital is fixed and lower than the rate of earnings. This maximizes the dividend to the
shareholders.
3. Lowering of the overall cost of capital The average cost of capital of equity shares, preference
shares and debentures is lowered down by the issue of debt capital as the cost of debt (interest
payable) is very low in comparison to the cost of other capital (dividends on preference and equity
shares).

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4. Tax-Advantages Interest payable on debt capital is and admissible expenditure in computing the
taxable income of the company while the dividend is not a deductible expenditure. Thus the cost is
reduced by the marginal tax rate applicable to that company.
5. Flexibility in Capital structure Debt capital provides flexibility in the capital structure because
debt can be rapid if it no more required by the business. Seasonal requirements are met by the
debt capital.
6. Only source for raising funds Sometimes company gets it difficult to raise funds through any
other source except that through debts. At times, especially during depression and recession, when
equity shares are not popular with the investors, debt capital is the only source for raising funds.
7. Low cost of Raising Funds Cost of issue of debt capital is much lower in comparison to equity
capital such as underwriting commission, expenses on certain formation etc.
LIMITATION ON DEBT FINANCE
A company cannot keep financing its affairs through debt capital to an unlimited extent. There are
following limitations on the debt financing.
1. Risk of Insolvency Due to periodical fixed payment of interest and principal. Creditors can claim
liquidation of the company if it fails in meetings its obligation.
2. Uncertainty of Income Interest on debt capital is a permanent charge against profits. A company
should avoid debt capital if its income is uncertain and irregular.
3. Cost of Borrowing Excessive, borrowing make debt funds costly and uneconomic. The cost of
borrowing increases with every successive borrowing.
4. Customs and Conventions In India such as jute, paper, electricity generation and distribution,
shipping etc. rely very much upon the debt capital due to customs and conventions of the industry.
5. Contractual Limitation If creditors such is banks or financial institutions impose certain
restrictions upon the firm that further loan cannot be taken by the firm without their prior approval, it
becomes a limitation on its borrowing capacity.
6. Fluctuations in the Income of Shareholders The debt capital creates fluctuations in the income
to the shareholders. The average is mainly governed by the degree of fluctuations in the rate of
return upon which equity holders investment is permitted by the management.
7. Conservative outlook of management As far as possible conservative management does not
rely upon the debt capital as the management loses its freedom by financing through debt capital.
in such companies the management prefer expansion and modernization through internal sources
rather than using external sources.
8. Change in corporate tax system Sometimes tax proposals may impose certain limitations on
debt financing.
MEANING OF DEBENTURES
A debentures is an instrument executed by the company under its common seal acknowledgement
indebtedness to some person or persons to secure the sum advanced. It is thus a security issued by a
company against the debt. In India, a public limited company is allowed to raise debt capital through
debentures after getting certificate of commencement of business, if permitted by its memorandum of
association. Indian companies Act says debentures includes debenture stock, bonds, and any other

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security of a company whether constitution a charge on the assets of the company or not. The definition
given by Prof. Naidu and Datta runs as follows A debentures is an instrument issued by the company
under its common seal acknowledging a debt and setting forth the terms under which they are issued and
are to be paid.
1. They constitute the loans capital of the company.
2. Debentures holders are creditors of the company.
3. Interest on debentures is paid at a fixed rate in periodical basis, such as six monthly, yearly etc.
4. Redeemable debenture capital has to be refunded after prescribed period.
5. Debentures carry to voting rights except under special circumstances.
6. Debenture holders can take legal action against the company, for and default in the matter of
payment of interest, or repayment of capital.
7. In case of any default by the company, the debenture-holders have the right to claim the payment of
their dues from the sale proceeds of those assets. For example if the company has created any
mortgage or charge on its assets to secure the issue of debentures.
8. Debentures holders can apply for winding up of the company if it is in their interest to do so.
ADVANTAGES OF DEBENTURES ISSUE
According to Guthmann and Dooneall, The use of debentures and bonds takes a capital market
unavailable to the corporation which offers only stock. Following are the advantage of debentures in the
corporate finance.
1. ADVANTAGES TO THE COMPANY
(i)

Lower Rate of interest The rate of interest payable on debentures is fixed and usually lower
than the rate of dividend paid on shares.

(ii)

Trading on equity A company is enabled to trade on equity by issuing debentures because

the rate of interest on debentures is usually lower than the rate of earning. Thus, the company
can declare a higher rate of dividend on equity shares.

(iii)

Freedom in Management As the debentures holders are not given any voting right to control
the affairs of the company, the company can raise the finance without surrendering control.

(iv)

Reduction is tax liability As per income tax rules, the payment of interest on debentures is
charged against profits of the company. While dividend is an appropriation of profit and hence
not a charge against profit. Hence, the profits of the company are reduced by the amount of
interest paid to debenture holders resulting in reducing the tax liability.

(v)

Surety of Finance According to the new guidelines issued by the Government of India in
1982, the secured debentures shall not be redeemable before a period of seven years. As there
is a surety of finance for that specific period the company may adjust its financial plans
accordingly.

(vi)

Capital from Ordinary Investors A company can collect the finance from such investors who
prefer fixed income with minimum risk rather than an uncertain high rate of dividend on capital
as security of capital is more important for them.

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(vii)

Finance During Boom - During boom, a company can easily collect the finance through the
issue of debentures because the psychology of investors is affected by the trends of the stock
market.

(viii)

Finance During Depression It there is a slump in the market, a company is not expected to
earn high profits, and the investors are not willing to invest their funds in share capital of a
company. Therefore, debentures are useful.

(ix)

Control on over-capitalization The state of over-capitalization is controlled by redeeming the

redeemable debentures, providing flexibility in the capital structure.

(x)

Consolidation of Debt. A company may consolidate its debts of short duration by issuing
debentures and thus may reduce its cost of capital.

2. ADVANTAGES TO INVESTORS
(i)

Fixed and Stable income As debentures carry a fixed rate of interest, an investor can
estimate his income well in advance. Thus debentures provide a fixed, regular and stable source
of income to debenture holders.

(ii)

Safe Investment As debentures holders have specific or general charges on the assets of the
company, so their investment is quite safe.

(iii)

Liquid Investment Debentures are more liquid investment, and have more ready market
because they are safe and can be used as collateral security by the investors in raising loan
from any financial institution. Under the new guide-lines (1982), the rights and secured
(convertible and non-convertible) debenture shall be listed in a stock exchange.

(iv)

Conversion of Loans In convertible debentures, debenture holders can convert their holdings
in shares at appropriate time.

DISADVANTAGES OF DEBENTURE ISSUE

1. DISADVANTAGES TO COMPANIES
(i)

Fixed Charge on Assets As debentures carry a fixed charge on all assets of the company,
the company cannot raise loan on such assets again, if needed.

(ii)

Fixed Burden Interest payable on debenture is a charge on the profits of the company, which
has to be paid even if there is no profit. This is a burden on the company particularly when there
are no profits or inadequate profits.

(iii)

Risk of Winding up If the interest on debenture is not paid by the company, the debenture
holders have a right to claim winding up of the company. Therefore, debentures issues is risky
in lean periods.

2. DISADVANTAGES TO INVESTORS
(i)

No Control As debentures holders are creditors and not the owners of company they get
no controlling authority over the affairs of the company.

(ii)

Share in Profits As debenture holders get a fixed income as interest irrespective of the
quantum of profits earned by the company, they do not share the profits even if a company
earns huge amount as profits.

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(iii)

Uncertainty of Redemption - In case of redeemable debentures payable within a specified

period, investors have uncertainty in their minds as to their redemption.

WHEN TO AVOID DEBENTURE ISSUE

Only a company having stability in income, can safety issue debentures to finance its long and medium
term requirements for the purpose of improvement and extension. In the following conditions a company
should avoid issue debentures.
(i)

Fluctuating earning.

(ii)

Low proportion of fixed assets to total assets as there is no substantial security to offer to
debenture holders.

(iii)

Manufacturing and supplying products with highly elastic demand such as luxury items.

(iv)

No sufficient profits to pay off interest on debentures.

TYPES OF DEBENTURES
According to different points of view following are the types of debentures.
1. FROM REDEMPTION POINT OF VIEW
(i)

Redeemable Debentures Redeemable debentures are to be repaid by the company at

the end of he specified period or within the specified period. It is at the option of the
company to give notice to debenture holders of its intention to redeem debentures at once
or by installment under the terms of issue.

(ii)

Irredeemable Debentures These debentures are repayable at any time by the company
during its existence. With no minimum fixed period these are redeemable if the company
fails to pay regular interest on them. These are also called perpetual debentures.
Debentures holders cannot claim their repayment during the life time of the company.

2. FROM SECURITY POINT OF VIEW

(i)

Naked, Unsecured or Simple Debentures These debentures carry no specific charge on

the assets of the company about the repayment of principal and interest. But being creditors
of the company, the debenture holders have general charge on the assets of the company.

(ii)

Mortgage or Secured Debentures These debentures are issued with a charge (fixed and
floating) on the assets of the company which may be on a particular asset or on all assets in
general. For this purpose, regular deed is ended into between the company and the trustees
of the debenture holders.

3. FROM THE POINT OF VIEW OF TRANSFER

(i)

Registered Debentures These debentures are registered with the company with names,
addresses and particulars of holdings recorded in a Debenture holders register. A regular
transfer deed giving full particulars of transfer and transferee is required at the time of
transfer of such debentures.

(ii)

Bearer Debentures These debentures are payable to the bearer. These are transferable
by delivery only. These are negotiable instruments and the company keeps no records for
them. Interest is paid to the coupon holder.

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4. FROM PRIORITY POINT OF VIEW

(i)

First Debenture These are those which are to be paid first in the event of winding up of
the company.

(ii)

Second debentures These are those which are to be repaid after the payment of first
debenture has been made.

5. FROM CONVERSION POINT OF VIEW

(i)

Convertible Debentures Holders so these debentures are given an option to convert

their holdings into shares under certain conditions and limitations mentioned in the
debenture certificate regarding the period during which he option may be exercised.

(ii)

Non-convertible Debentures These debentures cannot be converted into shares.

6. OTHER TYPES OF DEBENTURES

(i)

Collateral Debentures These debentures are issued by the company for the loan taken
from a bank or a financial institution as collateral security. These are effective only when the
company fails to pay the loans.

(ii)

Guaranteed Debentures At the time of their issue the payment of principal and the
interest on these debentures is guaranteed by some third party generally banks or
governments.

(iii)

Right Debentures These debentures are issued by the company to its resident
shareholders in the fixed proportion of their shareholdings. Such issue seeks to augment the
long-term resources of the company for working capital requirement and to reduce its
dependence on other short-term resources. These debentures cannot be issued for
expansion and modernization purposes. They will first be issued to existing shareholders
and then to shareholders in addition to their right depositions and employees and business
associates on a rational basis.

REDEEMABLE DEBENTURES
Redeemable debentures are those that will be repaid by the company under the term of issue at the end of
a specified period or at any time within a specified period by giving them a notice of its intention to redeem
them at the end of the notice period or by installments during the existence of the company. Redeemable
debentures may be reissued even after they have been redeemed until they been cancelled.
ADVANTAGES OF REDEEMABLE DEBENTURES
1. Flexibility in capital Structure By issuing such debentures the company can make its capital
structure more flexible, and raise funds as and when it needs the loan money.
2. Check on Over capitalization An over capitalized company may redeem such debentures and
may control the state of over capitalization.
3. Best solution for Fixed Term Loan If a company requires funds for a fixed period it may issue
such debentures because these can be redeemed after a certain specified period.

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4. Preferred by Fixed Term Investors These debentures are preferred by those investors who with
to invest their funds for a fixed term at a fixed rate of interest and at minimum risk.
DISADVANTAGES OF REDEEMABLE DEBENTURES

1. Liquidation of Company Redeemable debentures are repaid at the end of a certain specified
period or at any time within the specified period by giving them notice of redemption. If the company
fails to arrange the necessary amount to redeem them the debenture holders can take action for its
winding up. The companys existence is always at stake if its financial positions is not sound
enough.

2. Uncertainty of Redemption If debentures are repayable at any time within a specified period
under the terms of issue, it may create a problem before the debentures holders to invest the
amount immediately as soon as it is repaid by the company. There remains uncertainty in the minds
of debentures holders regarding its redemption.

3. Adverse effect on liquidity of Assets If a company has to repay a large sum at the time of
redemption of debentures it may adversely affect the liquidity of assets unless it is planned wisely
by creating sinking fund so that the company may get the required amount at the time of
redemption of debentures at the end of the specified period.
CONVERTIBLE DEBENTURES
Convertible debentures are those which are convertible into shares at the option of the holders after
a specified period. These are a means to deferred equity financing. A company intending to raise additional
equity capital at a particular time may find that the prevailing conditions in the capital market are not
congenial or the issue of equity shares. The investment project which is not likely to yield profit may not
succeed initially. Therefore, the company may issue debentures with the provision that holders will have
the optimum of converting them into equity shares after a few say 3 to 5 years.

ADVANTAGES TO ISSUING COMPANY

1. Rise in Equity Capital By such issue a company can rise equity capital indirectly without diluting
the earnings of the existing shareholders. By the time debentures are converted into shares the
additional investment starts earning an added return to support the additional shares.
2. Sale of Shares in Disguise In a period of low market prices of shares the company can sell
equity shares in disguise. Investors unwilling to purchase equity shares, initially, may like to convert
their debentures into equity shares if they find, it to be a profitable proposition.
3. Attracts Funds from Institutions By issuing convertible debentures, a company can attract
funds from the institutions which may not otherwise purchase equity shares due to restriction
imposed by their by laws.
4. Tax Advantage As the interest on debentures is a charge on profits, the company gets tax
advantage until the bonds are converted into shares.
5. Greater appeal Convertible debentures may have greater appeal among the investors
particularly in a period of tight money. The addition of conversion right allows the company to offer
comparatively a lower rate of interest in a period when prices of other bonds are falling due to rise
in the interest rates.

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6. Security for Other Debts As convertible debentures are unsecured and therefore the borrowing
capacity of the company remains intact by the issue of such bonds, the company can provide
security against its other debts.
7. Flexibility of Capital structure The issue of convertible debentures results in an element of
flexibility to the companys capital structure.
8. Double Benefits Convertible debentures offer benefits of both debt financing and equity
financing.

RIGHTS DEBENTURES
Under Section 81 of the Indian Companies Act 1956, there are specific provisions regarding the issue of
rights shares by the public companies while no such specific provision has been made regarding the
issue of rights debentures. Public companies are authorized to issue such debentures for raising long-term
resources. The central government has formulated certain guidelines to regulate the issue of rights
debentures by public companies for working capital requirements to be followed by a company, while
seeking consent of the controller of capital issue.

GOVT. GUIDELINES
Govt. concerning rights debentures guidelines are as follows:
1. These may be issued by only public limited companies
2. These may be issued to augment working capital on a long-term basis. Issue of debentures for any
other purpose such as financing of expansion project or addition to fixed assets will not fall under
this category.
3. The amount of the issue will not exceed 20% of the gross current assets, loans and advances
minus the long-term fund currently available for working capital, or 20% or the paid-up share
capital, including preference capital and free reserves, whichever is lower of the two.
4. The debt-equity ratio including the proposed debenture issue, should not exceed II.
5. The debenture will carry a rate of interest 10.5% payable half-yearly where the period of maturity is
up to and including 7 years and 11% where the period of maturity is from 8 to 12 years.
6. Rights debentures can be issued at a discount or additional interest of % can be offered for any
year, if in that year the rate of dividend on equity shares is highest in the preceding three years.
7. Rights debentures will be redeemable as follows:
a. Where the maturity period is upto 7 years, 33 1/3% of the debentures will be repaid
uniformly to all debenture holders in the 5th , 6th and 7th year.
b. Where the maturity period is from 8 to 12 years, 20% of the debentures will be repaid
uniformly to al the debenture holders in the 8th, 9th, 10th, 11th, and 12th year.
8. The face value of each rights debentures will be Rs. 100
9. Rights debentures will be listed with the stock exchange.
10. The issuing company should be a listed company. Its equity shares must be quoted on the stock
exchanges at or above par value in six months prior to the date of application for the issue.

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11. Rights debentures shall first be offered to the existing Indian Shareholders of company on a prorata basis and there after must be kept open for at least two months. The un-subscribed
debentures, if any, will be offered on a rational basis to (a) shareholders interested in taking up
additional allotment, (b) the directors of the company, and (c) the employees and business
associates of the company.
12. Allotment of Rights Debentures will be made only after a minimum subscription of 75% of the
amount of debentures has been secured.
13. The company should ascertain beforehand the prospects of at least 75% of the issue being take up
by the shareholders of the company and other categories of investors mentioned above.

REVISED GUIDELINES 1984

The government of India issued a set of guidelines by a notification in October 1980 in order to regulate the
issue of debentures. These guide-lines were revised in 1981 and 1982. In September 1984 the
Government of India announced following fresh guidelines for issue of secured convertible as well as nonconvertible debentures by public limited sector companies.
1. OBJECT OF ISSUE
(i)

Setting up of new projects.

(ii)

Expansion or diversification of existing projects.

(iii)

Normal capital expenditure for modernization

(iv)

Merger/amalgamation of companies in pursuance of schemes approved by banks/financial

institution and / or any legal authority.

(v)

Restructuring of capital as approved by banks/financial institutions and/or any other legal

authority.

(vi)

Acquisition of assets in accordance with legal provision and / or MRTP Act. and

(vii)

To augment long-term resources of the company for working capital requirement.

2. Quantum of Issue The amount of debenture in the case of working capital shall not exceed 20
percent of the gross current assets, loans or advances. In case of over subscription the companies
may be permitted to retain subscription for non-convertible debentures upto a maximum of 50
percent over the original issue.
3. Debt-Equity Ratio The debt-equity ratio shall not normally exceed 2.1
4. Interest Rate in case of convertible debentures, the rate of interest shall not exceed 13.5 percent
year while in case of non-convertible debentures, the rate of interest should not be more than 15
percent per year.
5. Period of Redemption Debentures shall not normally be redeemable before the expiry of the
period of 7 years.
6. Price at the time of redemption A Premium upto 5 percent of the face-value can be allowed at
the time of redemption in the case of non-convertible debentures only.
7. Denomination The face value of the debentures will ordinarily be Rs. 100 each.
8. Listing The debentures shall normally be listed stock exchanges.

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9. Security Only secured debentures will be permitted for issue to the public.
10. Under writing The issue of debentures shall be under written.
11. Listing of Shares of Companies proposing debentures issue The shares of the company
proposing to issue debenture must be listed in one or more stock exchange. Simultaneous listing of
shares and debentures of companies will also be permitted. The provision regarding listing of
shares is not applicable to public sector undertakings.

DEBENTURES UNPOPULAR IN INDIA

1. High Denomination In India, debentures are usually of high denomination, as India investors
prefer securities of low denomination, the moderate investors could not go in for them.
2. Managing Agency System Indian industries were financed primarily by the managing agents
who generally discouraged the issue of debentures for fear of loosing their financial importance.
3. Heavy Stamp Duty Debentures have been a very costly source of finance with a heavy
stamp duty of Rs. 15 for Rs. 1000 for bearer debentures and Rs. 7.50 per Rs. 1000 for
registered debentures. This heavy stamp duty generally discourages the investors to invest
funds in debentures.
4. Adverse Attitude of Banks Banks and other financial institutions show an adverse attitude
towards companies which issue debentures. Banks did not entertain the debentures even as
collateral securities. Issuing Companies lose their credit in the eyes of banks and other financial
institutions.
5. Limited Marketability For debentures there is no developed, regular and steady capital
market in India. To increase the marketability of industrial securities the Government of India
have recognized many new stocks exchanges in different part of the country.
6. Adverse effect of Government securities Government of India have issued so many
securities with attractive conditions which have adversely affected the popularity of debentures
in India. As compared to the industrial securities government securities are considerably safer.
Institutions investors have to invest their funds in government securities as per statutory
provisions.
7. Unattractive terms of issue Terms of issue of debentures in India are not as attractive as
they are in some other industrially developed countries.
8. Lack of Proper Advisory Agencies There is a total lack of advisory agencies investment in
India. Stock exchange services are confined to some big cities. Investment trusts and
investment banks are not developed in India. Therefore the investor cannot judge where to
invest the funds.
9. Lack of Interest to Industrial Investors Institutional investors are statutorily required to
invest a large part of their funds in government securities. For example, Indian Insurance Act
1939 prohibits investment in debentures by insurance companies in India. Even to day Life
corporation invests its 80% of funds in government securities. Generally Indian banks do not
invest in long-term corporate securities. Investment bank and investment trust have not
developed much in India. Recently, Unit Trust of India as show some interest in corporate
debentures.

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10. Cautious Attitude of Indian Investors Indian investors are very cautions about the safety of
their investment. They do not wish to earn more at the cost of safety. Only safety of investment
attracts them to invest funds in gilt-edged securities.
11. Preference for Government Savings In recent years Indian government have initiated a
number of attractive saving schemes and issued securities which carry income tax rebates and
other benefits like withdrawals etc. Marginal investors prefer these schemes rather to invest
funds in debentures.
12. Limited Control of Holders Debenture holders are given limited controlling power in the day
to day affairs of the company unless their interests are affected. They have no vice in policy
decision of the company unless they affect their interest. Hence those who desire to have a
voice in the affairs of the company prefer to invest their money in equity shares.
STEPS TO MAKE DEBENTURES POPULAR
In recent years the government have taken several steps to make debentures a popular source of
finance. As against a meager 10 percent in 1966-67, today debentures capital accounts for more than 1/3
of the total corporate funds. Following steps have been taken by the govt. to make debenture popular as a
source of finance of India.
1. Attractive terms Debentures with attractive terms such as convertible debentures have been
issued. Convertible issued by well-known companies like TELCO, Reliance Industries Ltd., etc.
have been over-subscribed.
2. Conversion into shares The conversions of debentures into shares encourages the institutional
investors to invest in debentures.
3. Relaxation in Stationary restrictions Statutory restriction on the institutional investors like LIC
and IFC have been relaxed. Hence they feel encourage to have debenture in their investment
portfolio.
4. Bank cooperation There has been a market change in the attitude of banks which no longer
consider a company issuing debentures as less credit-worthy.
5. Underwriting facilities The development of issue and underwriting facilities have enhance the
market for debentures.
6. Trustee service Trustee services are being made available to debenture holders.
7. Better Security through Joint Issue Sometimes companies under the same management
combine to make a joint issue of debentures. As a result they are able to offer better security to
investors in the form of assets and the cost of issue is distributed.
8. Tax Savings Payment of interest on debentures allowed as an item of expenditure under the
Income Tax Act. This has acted as a spur to companies to issue debentures. Less formalities have
to be observed while issuing debentures. The benefit of trading on equity is also available.
Some of the steps which are likely to increase the popularity of debentures in the country are reorganization of the capital market to provide better marketing facilities for debentures, change in
attitude of banks towards debentures, more attractive terms to debenture etc.

MEANING OF PUBLIC DEPOSIT

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The term public deposit includes money received by a non-banking company by way of deposits or loan
from the public including the employees, customers and shareholders of the company other than in the
form of shares and debentrues. In order to meet their medium term and long-term requirements Indian
fianc companies have been receiving public deposits for a long time. Before independence, banking
facilities in the country were not well developed. People preferred to deposit their saving with reputed
companies. in the recent years Public deposits have again become popular as rates of interest offered by
companies are higher than those offered by banks. The cost of deposits to the company is less than the
cost of borrowing from banks. Companies generally accept public deposit varies from 12 percent to 15
percent depending on the period of deposit and reputation of the company.

PROCEDURE OF PUBLIC DEPOSIT

According to the Companies (Acceptance of Deposits) Rules 1975 as amended in 1984, no company can
receive secured and unsecured deposits in excess of 10 percent and 25 percent respectively of the paid up
shares capital plus free reserves. Since April 1, 1980, public sector companies have been also permitted to
invite public deposits. The company which intends to raise public deposits approaches the public through
an advertisement in the press about the progress and prospect of the company to induce the public to
deposit their surplus money with the company. The depositors may withdraw their balance after the
specified period or after giving notice. The receipt of public deposits is governed by the rules made by the
Central Government under section 58A and B of the Companies Act and directions issued by the Reserve
Bank of India.

ADVANTAGES OF PUBLIC DEPOSIT

Following are the advantages of public deposit :
1. Simplicity Raising capital through public deposits is a relatively simple affair. There are few legal
formalities. The company receiving deposits is only required to issue a receipt to each depositor.
2. Economic Public deposits are cheaper to raise. By only advertising in the newspapers for public
deposits the company can collect the necessary funds in a short period. It can save on underwriting
commission, brokerage etc. Thus interest on public deposits works out to be much less than liability
in the form of dividend on shares or interest on debentures.
3. Trading on equity Funs raised through public deposits enable the company to trade on the
equity. As interest on public deposits is paid at a fixed rate, the entire remaining profits are available
for distribution among equity shareholders of the company.
4. Valuable source of short-term finance Public deposits are a valuable source of shot-term
finance. They prove very useful in case of companies depending on raw materials which is
available only in a particular season of the year and for meeting other short-term liabilities. These
companies can buy enough quantities of raw materials through such deposits. As the sale of their
finished product picks up, they are enabled not only to pay interest on the deposits but also to save
for the eventual repayment.
5. No charge on assets Public deposits do not create any charge or mortgage on the companys
assets like debentures. Thus the company may raise loans against the security of its assets to meet
other requirements.

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DISADVANTAGES OF PUBLIC DEPOSIT

(i)

Uncertain A person who has made a deposit with a company can withdraw his at any time he
pleases on the only condition that he has to give a prior notice to the company. Though this
facility helps the depositor, premature withdraws by depositors, may effect the companys
financial position, particularly if its earnings have become unstable. The company may find it
difficult to honour its commitment and repayment, if a large number of depositor decide to
withdraw their deposits at a time when the business in general is faced with depression and
slump.

(ii)

Fair weather friend The company may be flooded with deposits when its earnings show a
rising trend. But in times of financial crisis the depositor might desert it as a sinking ship is
deserted by its crew.

(iii)

Reckless trading and speculation As raising of deposits from the public is relatively
simple and inexpensive affair, sometimes it tempts the companies to raise more funds than they
can profitable use. This results in over-trading or speculation activities on their part, with harmful
consequences for the business of the undertaking.

(iv)

Little attraction for professional investors Public deposits do not hold much attraction for
professional investors as a mode of investment. Progressive investors do not opt for deposits
because of low return and absence of capital appreciation. The conservative investors keep
away from making deposits due to absence of proper security in the form of a mortgage or
charge on the assets of the company.

(v)

Hammer to growth of capital market Public deposits hamper the growth of a sound
capital market in the country. As the companies find it easy and economical to raise money
through public deposits they are not very keen to raise money by issue of shares and
debentures. Thus, investors are deprived of the benefits accruing from good securities.

(vi)

Uneconomical If better investment opportunities are freely available, the public will not keen
to make deposits unless very high rates are offered. The company raising money through public
deposits has to spend a lot by way of commission and brokerage. Thus, in the ultimate analysis
this sources of capital proves to be costly.

METHODS OF RETIRING OF LONG TERM DEBTS

A company has to redeem every debt-except the irredeemable debentures. Which are to be repaid
at the option of they company at any time after giving a due notice to the debentures holders. Following are
the three principal methods repayment of long-term indebtedness: Redemption, Refunding and conversion.
1. Redemption Redemption involves cash payment to the debenture holders or bond holders either
at or before the date of maturity according to the terms of contract. Payment is made (i) at maturity,
(ii) before maturity under terms of issue, and (iii) after maturity not under the terms of contract but
under a subsequent agreement.
(i)

At maturity Payment is made on the due date out of cash which may be made available
either out of current earnings or out of sinking fund created out of profits established to

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ensure payment of debentures at maturity. Investment against sinking fund are sold out and
loan is redeemed in order to make cash available.

As a company cannot redeem its entire bond issue from the earnings of any one year, a sinking
fund is built up out of profits over a number of years without injuring the financial operations of the
company. It is invested in various securities, especially in gift-edge securities, in such a way that total
amount of indebtedness is collected including interest, on investment after a fixed period. Following are the
main reasons for creating sinking fund.

(a) Security It adds the element of security.

(b) Confidence It tends to inspire the confidence in the capacity of the issuing company.
(c) Check It acts s a check on the financial policies of the management due to appropriations of
profits for the fund.

(d) High credit The company is rated high because the company invests the amount equal to the
fund in the open market securities, which tends to stabilize the market value of bonds at a relatively
high level.

(e) Makes up depreciation It makes up the depreciation in the value of assets purchased out of the
sale proceeds of bonds.
(ii)

Before maturity A company may redeem debentures even before maturity which may be
mandatory or solicited. This is as follows:
(a) If its mandatory, the bounds are chosen by lot for redemption. The issuing company
reserves the right to redeem the debentures as given under the terms of debenture
agreement at the time of issue. Payment may be made in fixed installments year after
year. The number of debenture to be redeemed in a year is drawn by lot. Slips
containing distinct number of debentures of bonds are put in a drum and then as many
slips are taken out as the debenture to be redeemed. The debentures thus drawn by lot
are repaid in cash and full under terms of contract.
(b) If redemption is solicited before maturity, an agreement is entered into between the
company and the debenture holders.
(c) A company may redeem debentures before maturity by purchasing them in the open
market. If the terms of issue do not restrict the company from doing so the company may
cancel these debentures after their purchase in the open market.

A company is promoted to redeem before maturity a due to the following reasons:

(a) To eliminate fixed charge on the earnings of the company provided the liquidity position of the
company is not adversely affected.
(b) To get rid of onerous terms and conditions of the bond.
(c) To redeem debentures either by taking them back direct from the debentures holders or by
purchasing them from the open market.
(d) To provide flexibility to the financial plan of company.

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2. Refunding Refunding of indebtedness means replacement of old debt into new instead of
extinguishment of debt altogether a is done in redemption. This may take place either or maturity or
before maturity.
(a) On maturity this may be done in two forms
(b) Before maturity This is done by exercising call option given under the terms of issue or if no
such optionis given in the managemnet, the company may enter into a first agreement with the
bond holders including them to accept new series of debenture or to accept cash before
maturity. Following types of inducements are offered to the bondholders for persuading them to
accept new bonds.
(i)

New bonds may issued at a discount to the existing debentures.

(ii)

It is likely to find favour with the old bondholders.

(iii)

The bondholders of small issues may have the advantage of better security by
consolidating the issue with after acquired property clause.

(iv)

New issue may be guaranteed by the parents company affiliated company or

government of financial company.

(v)

Old debentures may be redeemed at premium.

(vi)

Debenture may be paid partially in cash and bonds for the balance.

If the bondholders insist on cash payment, it may be arranged to make the new issue under written with the
bankers. Following are the reasons for refunding before Maturity:
(i)

To reduce fixed change.

(ii)

To eliminate bonds containing prohibitive term and conditions by offering new bonds in
favourable market.

(iii)

To consolidate several bonds containing different terms and conditions.

3. Conversion Conversion means issue of shares to the existing debentures holders in exchange of
their holdings under the terms and conditions specified in the contract of issue. The debenture
holder is given a right to convert the debentures within a specified period according to the terms
given in the bond indenture. The company retires it as debt by converting debentures into equity or
preference shares. The main purpose of issuing convertible debentures is to make the financial
plan of the company highly elastic because such debentures may be redeemed at any time before
maturity. To conclude the redemption of debentures is preferred when the company has sufficient
cash to pay off the debentures. On the other hand, if the company lacks funds to pay off debentures
in cash, it issues a new series of debentures. If the company likes to continue the indebtedness for
the purpose of trading on equity or due to favourable market conditions, it may adopt the method of
refunding.
DEBT FINANCE AGAINST EQUITY FINANCE
Debt Financing is recommended against equity financing due to following reasons:
1. The rate of interest payable on long terms debt is lower than the normal rate of return.
2. The cost of debt-financing is always fixed.
3. The interest payable on debt is an admissible deduction for income-tax purposes which reduces
tax liability of the corporation.

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4. Debt carries flexibility in the capital structure of the company because it can be redeemed at any
time at the sweet will of the company.

Following are the circumstances of accepting debt capital.

(1) The sales and earnings are relatively small
(2) The marginal cost of debt is less than the cost of equity as it lower the average cost of capital or
trading.
(3) The general price level is expected to be high, resulting in higher profits in future.
(4) The existing debt-ratio is relatively low.
(5) Price earnings ratio on equity shares is low in relation to the level of interest rates.
(6) Retention of existing control pattern because debentures carry no voting rights.
(7) Terms of debt-agreement are not burdensome on the cash position of the company.
(8) Terms and conditions of debt agreement are not onerous and prejudicial to the interest of the firm
and its shareholders.

SUITABLE DEBT MANAGEMENT POLICY

An optimum debt policy depends on expected ratio of returns and the rates at which these expected
revenue streams will be capitalized. No matter how much it shifts towards debts a company can never
lower its average cost of capital unless it chalks out or maintains a suitable debt management policy, which
means a balanced and cautious debt policy to remove the fluctuations in the earnings per share.
(i)

In the years of prosperity Through earnings per share will increase if the company relies
more on debts rather than equity financing but it creates its own problems that all manages
cannot appreciate because it restrains the freedom on the working of financial policies.

(ii)

In the period of depression It is not interest of the organisation and the shareholders to raise
debt capital because the average rate of earnings is much lower than the rate of interest
payable on such debts. The company must follow the policy of balanced debt financing policy in
order to avoid sharp fluctuation in the earning per equity share.

PLOUGHING BACK OF PROFITS

Ploughing back of profits is a management tool under which management does not distribute the whole of
the profits earned during a year to the owners of capital but it retains a part of it to be utilized in future for
financing the schemes of development and betterment of the company and / or meeting the special fixed or
working capital requirements of the concern. It is the best devise to finance the schemes of expansion,
modernization, and betterment for an existing company. Ploughing back or re-investment of profits is and
adjunct of sound financial management. It raises no problem or complication as does borrowing either from
the banks or from the public. The reserves may be built up during a continuously spell of prosperous period
by following the conservative dividend policy and without touching the capital structure of the company and
may be used during emergency. It will help the company during depression however serious. According to
this device, a part of the total earnings may be transferred to various reserves, e.g., General Reserves,
Repair and Renewal Reserve Fund etc. Sometimes secret reserves are created by the directors without

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the knowledge of the shareholders to make the financial position of the company sound. It is a desirable
practice to stabilize the economic soundness of the company.

1. ADVANTAGES OF PLOUGHING BACK OF PROFITS

(i)

As a Shock absorber in the Business The policy of ploughing back of profit provides a
cushion to absorb the shocks of business vicissitudes. It is well known that prosperity does not
last for ever. Period of boom is always followed by depression. In depression past earnings
enable the company to withstand the seasonal reactions and business fluctuations and act as a
shock-absorber in the business.

(ii)

No Dependence on Fair Weather Friends Retained earnings, may be called All weatherfriend. In the absence of ploughing back of profits a company has to manage its funds for
expansion or development through other sources of long-term finances such as issue of shares
or debentures or borrowings from long-term financial institutions or public deposits. There are
labeled as fair weather friends because a company can manage its finance through these
sources only in prosperity. In adversity, these source cannot be realized upon. Only retained
earnings can be utilized for such development schemes.

(iii)

Economic Method of Financing : Ploughing lack of profits is a cost free sources of finance as
nothing is paid to retain the profits. If a company issue shares or debentures of borrows money
from financial institutions or public to finance its schemes of development, it will have to pay
dividends or a fixed rate of interest on such financing. Moreover, interest on borrowings is a
charge on the profits of the company. It is to be paid whether profits are available or not. But if
reserves are used for such purpose, no such obligations of dividend or of interest is incurred.

(iv)

Best device Financing of Rationalization Ploughing back of profits is the best device in
financing rationalization schemes. Retained earnings may be employed when a company
expands its business or implements any scheme of development, mechanization, automation
etc. In comparison to other sources of finance, there are three additional charms of this device.
a. There is no dependence on outside sources
b. No charges or encumbrances is created on the fixed assets of the company.
c. There is no cost of retaining earnings.

(v)

Ensure stable Dividend Policy Retained earnings ensure stable dividend policy and
enhance the credit standing of the company in the market. Even if the earnings of the company
are not stable and regular it may maintain a consistence rate of dividend to the shareholders in
prosperity and transfer any excess to a reserve which may be called divided equalization fund.
When the earnings of the company are below the normal rate of earnings, in depression it may
maintain the rate of dividend in that years also by madding up deficit from dividend equalization
fund.

(vi)

Easy to Replace the Wasting Assets Generally depreciation is charged on the assets taking
into consideration the present cost and the life of a particular asset. Replacement costs is very
often ignored which increases three to four times of the present price due to rise in the price
level during the expiry of life of existing assets. This makes depreciation funds or replacement
fund insufficient to replace the worn out asset. Under these circumstances, the ploughed back
profits can be utilized to make good the deficiency.

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(vii)

Easy Retirement of Bonds or Debentures The undistributed accumulated income can also
be used to redeem the bonds or debentures which relieves a company of the fixed burden of
interest charges.

2. ADVANTAGES TO SHAREHOLDERS
i)

Safety of Investment Every investors cherishes that his investments should be safest and
the return on the investment should at least constant, if not increasing. The policy of ploughing
back of profits assures that
a. The dividend rate will be rationalized
b. The investments is quite safe and sound and
c. The company can easily withstand the business cycles and seasonal reactions.

ii)

Enchanted Market Value of Share By declaring dividend to shareholders at more or less

stable rare or at a higher rate than that of the previous year a company earns repute. The
market value of its shares goes up. Shares holders can take a advantage of the increased
market value by selling their holdings in the open market.

iii)

Profits by Retaining the Shares If shareholders do not like to sell their shares at higher
market price, they can retain shares. They may be benefited by the increased earning capacity
of the company as the actual value of their shares will be higher.

iv)

Higher Collateral Value The increased value of shares enables the shareholders to borrow
the amount against the securities of such shares on better term. Thus they are treated as
collateral securities for loan.

v)

Super Tax Section 104 of the Income tax Act provides no super tax to the shareholders of
closely held companies being owned by a few shareholders. This section provides safeguard
against the practice of ploughing back of profits in closely-held companies.

3. ADVANTAGES TO THE COUNTRY OR NATION

i)

Aid in Capital Formations The corporate savings are one of the important means of capital
formation which is very important for the economic prosperity of an underdeveloped country.
Various new projects in the industrial or other spheres are commenced which would otherwise
remain unexpected because of shortage of finance. Thus ploughing back of profits indirectly
stimulates the rapid industrialization.

ii)

Smooth and Continuous Production Every nation is interested in the smooth and
continuous functioning of the old and new enterprises. Corporate savings provide the stability
and flexibility which are indispensable for the successful operations of companies without which
the industrials mortality rate is likely to be higher.

iii)

Quick-Financing of Rationalization Schemes Corporate savings or a accumulated profits

provide an assurance to the management for quick implementation of rationalization schemes
like expansion of industrial activity and improvement of the existing units, such schemes may be
put off or delayed in the absence of retained profits.

iv)

Greater, Better and Cheaper Production - Internal financing provides an easy finance for
rationalization, modernization and automation schemes without any legal formality and charge
on profits. It facilitates greater and better production at cheaper rates to society which will

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increase its standard of living. In the long run the policy of retained profits goes to increase the
standard of living of the masses.

DISADVANTAGES OF PLOUGHING BACK OF PROFITS

1. Misuse of Savings If the corporate savings are not utilized in the lager interest of shareholders
the management may use them in weaker units under the same management and ownership or in
their pet concerns or in which the shareholders may be least interested.
2. Creation of Monopolies The ploughing back of profits serves vested interests. Carried to its
logical conclusion, it may tend to create monopolies because as a result of reinvestment of their
profits into their own enterprise the existing companies may grow more and more while new
concerns would find it difficult to raise the capital they need.
3. Manipulation in the value of Shares The enormous accumulated earnings provide a greater
scope to the management for manipulation in the value of shares by manipulation the rate of
dividend. As the rate of dividend to be declared is the sole authority of the board of directors it
cannot be increased even by all the shareholders in the general meeting. With an intention to bring
down the market price of shares and purchase them at lower market price, the directors may
declare a lower rate of dividend. In the subsequent year, of rate of dividend may be increased out of
the past accumulated profits to raise the market value of shares with an intention to dispose of their
holdings at such increased price. Ignorant shareholder may fall a prey to these tactics and
fraudulent practices of the management.
4. Over Capitalization The accumulated reserves may lead over capitalization because the
management may be inclined to capitalize its reserves by issue of bonus shares which will reduce
the rate of dividend.
5. Interference with the Freedom of Investors An excessive cautious dividend policy refers with
the freedom of the investors whether the management wants that old industry should expand or
they should finance the setting up of a new concern.
6. Social Waste Excessive ploughing back profits entails social waste because money is not made
available to those who can use it to the best advantage of the community, but is retained by those
who have earned it.
7. Dissatisfaction among Shareholders An over-enthusiastic policy of ploughing back of profits
may create dissatisfaction among the shareholders because they think that the management is
damaging their interest by retaining the profits and thus paying a lower rate of dividend that may be
paid out of the available profits. Most of the shareholders are not happy with this policy.
The analysis of the merits and demerits of the policy of ploughing back of profits, makes it clear that
it is undoubtedly a good policy for the development of the industry but the management should be
cautious and bold enough in carrying out the policy.
INTERNAL FINANCING
A new company has only external sources finance. However, an existing company can also
generate finance through its internal source. The two most important source of internal financing are
depreciation and retained earnings. Each of these internal sources of financing are explained below.
1. Depreciation as a source of finance

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Depreciation means decrease in the value of assets due to wear and tear, lapse of time, obsolescence,
exhaustion and accident. There is a lot of controversy among academicians and business executives
regarding treatment of depreciation as a source of funds. People who oppose treating depreciation as a
source of finance argue that funds are generated by operating profits and not by making provision for
depreciation. If depreciation were really a source of finance by itself any enterprise could have
improved its position at will by increasing the periodical depreciation charge. They further argue that the
depreciation being a non-cash item of expense does not affect the working capital of the firm and as
such not at all a source of finance.
Validity of the above arguments cannot be questioned, but it can also not to be denied that as a noncash expense, depreciation does not represent any cash outlay with the result that a part of the profits
adjusted for depreciation can be used by management to increase any of the current assets or pay
taxes, dividend etc. Depreciation may, therefore, can be taken as a source of funds in a limited sense
because of the following reasons.(i)

Depreciation finds its way into current assets through charging of overheads (including
depreciation). The value of closing inventory may include depreciation of fixed assets as an
element of cost.

(ii)

Depreciation does not generate funds but it definitely saves funds. For example, if the
business had taken the fixed asset on hire, it would have been required to pay rent for them.
Since, it owns fixed assets, it saves outflow of funds which would have otherwise gone out in
the form of rent.

(iii)

Depreciation reduces taxable income and, therefore, income-tax liability for the
period is reduces. This will be clear with the following example:
Case I

Case II

Rs.

Rs.

75,000

75,000

Nil.

15,000

Taxable Income

75,000

60,000

Income Tax say at 50%

37,500

30,000

Net Income after tax (B)

37,500

30,000

Net Flow of funds after tax (A) + (B)

37,500

45,000

Income before depreciation

Depreciation Income

The above example shows that in Case II, the net flow of funds is more by Rs. 7,500 as compared to Case
I. This is because on account of depreciation charge being claimed as in expense, tax liability has been
reduced by Rs. 7,500 in Case II. It may, therefore, by said that true funds flow from depreciation is the
opportunity of saving cash outflow through taxation.

2. Financing through retained earnings

This is strictly not a method of raising finance but refers to accumulation of profits by a company to
finance its development activities or repay loans. It is also known as Internal Financing or
ploughing back of profits. According to the latest provision of the Companies Act, a certain
percentage, as prescribed by the Central Government (not exceeding 10%) of the net profit tax of a

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financial year have to be compulsorily transferred to reserves by a company before declaring

dividends for the year.
Merits This method of raising finance for a company is very useful because on the one hand it does
not cost anything to the company and on the other hand it strengthens the financial position of the
company. The chief merits of this method of financing can be put as follows:
(i)

It enhances business reputation and increases the capacity of the business to absorb
unexpected and sudden business shocks too.

(ii)

As compared to other sources of financing, this method of financing is least costly since it does
not invoice any floating cost as is the case with raising of funds by issuing different types of
securities. Of course, it may not be wholly correct to say that retained earnings have no cost to
the company. As a matter of fact, the cost of retained earnings is the return which the
shareholders could have earned on the amount of retained earnings if it had been distributed.

(iii)

This method of financing has been broadly found to be useful for financing expansion and
improvements.

(iv)

This source of financing is also useful since it carries no fixed obligation regarding payment of
dividend or interest.

Demerits Financing through retained earning is not free from evils or misuse. The demerits as
consequences of such misuse can be summarized as follows:
(i)

The retained earnings can be misused by the management to manipulate the value of the
companys shares in the stock exchange and also to cover their inefficiency in managing the
affairs of the company.

(ii)

Excessive use of retained earnings continuously for long period may result in converting the
company into a monopolistic organisation.

(iii)

The method of financing through retained earnings may prove harmful to social interest also.
The retained earnings are utilized by individual business units and the society does not get the
chance of investing them through capital market into such business units which may be more
useful to the society.

(iv)

The shareholders may also object to the use of retained earnings as a source of finance since it
affects their regular income. This is particularly true for shareholders falling in lower income
groups.

The quantum of retained earnings is affected to a great extent by the dividend policy pursued by a firm.
The higher dividend rate means less retained earnings and vice versa.

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UNIT VII
SOURCES OF FINANCE
LOAN FINANCING
A firm may meet its financial requirements by taking both short-term loans / credits and long-term loans.

1. SHOT-TERM LOANS / CREDITS

The short-term loans / credits are obtained for working capital requirements. The following are the
important sources of short-term loans / credit.

(1) Trade Credit Trade credit is a form of short-term financing common to almost all types of
business firms. As a matter of fact, it is the largest source of short-term funds. In an advanced
economy, most buyers are not required to pay for goods on delivery. They are allowed a short-term
credit period before payment is due. This credit may take the form of (a) An Open Account Credit
Arrangement (b) Acceptance Credit Arrangement.
In case of an Open Account Credit Arrangement, the buyer does not sign a formal debt instrument as an
evidence of the amount due by him to the seller. While in case of an Acceptance Credit Arrangement the
buyer accepts a bill of exchange or gives a promissory note for the amount due by him to the seller. Thus,
it is an arrangement by which the indebtedness of the buyer is recognized formally.
Trade Credit Arrangement is generally made available to the buyer on an informal basis without creating
any charge on assets. Trade Credit Arrangement usually carry stipulation of allowing a cash discount to the
buyer for prompt payment. The volume of trade credit and its popularity as a means of short-term financing
depends on the following factors.
(i) The terms of trade credit, (ii) Reputation of the purchasing firm, (iii) Financial position of the
seller, and (iv) Volume of purchase to be made by the buyer.

Merits of trade credit

(i)

The major merit of trade credit as a source of finance is its ready availability.

(ii)

Trade Credit is available on a continuing and informal basis. There is no need to arrange
financing formally. In case, the firm is not taking cash discounts, additional credit is readily
available by not paying existing trade creditors till the expiry of the credit period. There is no
need to negative with the supplier. The decision is entirely up to the firm.

(iii)

There is no need of creating any sort of charge against firms assets for obtaining the trade
credit.

(iv)

Trade Credit is a flexible means of financing since the firm does not have to sing a note,
pledge securities or adhere to strict payment schedule. A seller views occasional late
payment with a far less critical eye than a banker or any other lender.

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Demerits of Trade Credit

(i)

The cost of trade credit may be very high in case all factors are considered. The seller while
fixing the selling price of his products to be sold on credit takes into account the interest, the risk
and inconvenience attached with supplying goods on credit. As a matter of a fact, many firms
utilize other sources of short-term financing in order to enable them to take advantage of cash
discount.

(ii)

Availability of liberal trade credit facilities may induce a firm to over trading which may later
prove to be disastrous for the firm.

The firm must balance the advantages of trade credit as a discretionary source of financing without any
explicit cost against the cost of losing of cash discount, the possibility of deterioration in reputation, if
trade credit is stretched beyond agreed limits and the increased purchase price of the product.

2. Commercial Banks
Commercial banks in our country mostly provide only short-term credit to the business. They have
started providing medium term finance also, but only marginally.
Commercial banks make advances to the customers in the following forms:
(i)

Loans : A loan is a kind of advance made with or without security. In the case of loan the banker
makes a lump sum payment to the borrower or credits his deposit account with the money
advanced. It is given for a fixed period at an agreed rate of interest. Repayments may be made
in installments or at the expiry of a certain period. The customer has to pay interest on the total
amount advanced whether he withdraws the money from his account (credited with the loan) or
not. A loan once repaid in full or in part cannot be drawn again by the borrower unless the
banker sanctions a fresh loan.

The rate of interest charged by a bank in the case of loans is usually lower than in case of cash credits
and overdrafts on account of the following reasons :
(a) It involves lower cost of maintenance on account of not frequent operation of the account.
(b) The bank gets interest on the total amount sanctioned whether the customer withdrawals the whole
money or not.
Loan may be a term loan or a demand loan. Payment of term loan is spread over a long period. It
includes a medium term loan (repayable) within 1to 5 years) and a long-term loan (repayable after 5
years). Demand loan is payable on demand. Thus, it is for a short period.
(ii)

Cash Credits : A cash credit is an arrangement by which a banker allows his customer to
borrow money up to a certain limit. Cash credit arrangements are usually made against the
security of commodities hypothecated or pledged with the bank.

(iii)

Hypothecation : In case hypothecation the possession of good is not given to the bank. The
goods remain at the disposal and in the godown of the borrower. The bank is given access to
goods, whenever it so desires. The borrower furnishes periodical return of stock to the bank.
Such an advance is granted by the bank only to persons in whose integrity it has full
confidence.

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(iv)

Pledge : In the case of pledge, the goods are placed in custody of the bank with its name on the
godown where they are stored. The borrower has no right to deal with them.

Customers favour hypothecation to pledge because the latter is considered to lower this prestige.
Cash credits are the most favorite mode of borrowing by large commercial and industrial concerns in India,
on account of the advantage that a customer need not borrow at once the whole of the amount he is likely
to require, but draw such amounts as and when required. He can put back any surplus amount which he
may find with him for the time being. Interest on a cash credit account has to be paid only on the amount
actually drawn at any time and not on the full amount of the credit allowed. In order to safeguard the banks
interest on a account of bankers locking of funds unnecessarily because of customers drawing funds
much less than the banks estimate, a minimum interest clause is often inserted in the cash credit
agreements. The clause requires the customer to pay interest to the bank on a certain proportion of
amount arranged for, say, one third, one-fourth, even though he may not have drawn to this extent.
(v)

Overdrafts : The customer may be allowed to overdraw his current account, with or without
security if he requires temporary accommodation. This arrangement, like the cash credit, is
advantageous from the customers point of view as he is required to pay interest on the actual
amount used by him. A cash credit differs from an overdraft in the sense that the former is used
for long terms by commercial and industrial concerns doing regular business, while the latter is
supposed to be a form of bank credit to be made use of occasionally and for shorter durations.

(vi)

Bills discounted and purchased : The banks also give advances to their customers by
discounting their bills. The net amount after deducting the amount of discount is credited to the
account of the customer. The bank mayh discount the bills with or without security from the
debtor in addition to the personal security of one or more persons already liable on the bill.

The term discounting of bills is used in respect of time bills while the term purchasing of bills is used
in respect of demand bills.
Merits:
1. Short-term credit from commercial banks is generally cheaper as compared to any other source of
short-term finance.
2. Commercially banks, as explained above, have different schemes of financing thereby considerably
flexibility can be maintained.
3. Commercial banks also provide credit to trade and industry at concessional rates under their
special schemes as per the directives of the Reserve Bank of India.
4. Commercial banks also act as friend, philosopher and guide to their client business firms in respect
of the new ventures to be taken up and the most appropriate sources from which finances have to
be raised by them.
Demerits :
(i)

Financing from commercial banks requires signing of a number of documents involving cost as
well as time.

(ii)

Commercial banks rarely grant unsecured credit to business firms. This acts as deterrent for the
firms to depend more on commercial banks for their financial requirements.

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(iii)

A commercial bank takes a very critical view of even a small irregularity committed by its
customer in respect of the operation of his account.

3. Public Deposits
Many companies accept deposits for short periods from their members, directors and general public. This
mode of raising funds is becoming popular these days on account of bank credit becoming quite costlier.
According to the existing provisions, a company cannot accept deposits for a period of less than 6 months
and more than 36 months. The maximum rate of interest on public deposits depends as RBI directives.
However deposits up to 10% of the paid up capital and free reserves can be accepted for a minimum
period of three months for meeting short term requirements. Moreover, a company cannot accept or renew
deposits in excess of 35% of its paid-up capital and free reserves.
Merits
(i)

Financing through deposit is simple without much of complicated formalities involved. The
company has simply to advertise and inform the public that it is interested in and authorized to
accept public deposits.

(ii)

It is a less costly method for raising short term as well as medium term funds required by the
business.

(iii)

There is no need of creation of any charge against any of the assets of the company for raising
funds through public deposits.

(iv)

The company can take advantage of trading on equity since the rate of interest and the period
for which the public deposits have been accepted are fixed.

Demerits
(i)

Raising funds through public deposits is not a reliable and definite source of finance. A company
enjoying good reputation in the market is in a positions to raise sufficient funds through public
deposits. However, companies which do not enjoy such reputation cannot raise sufficient funds
by this method. More ever, in a period of depression and financial stringency this source will dry
up.

(ii)

This mode of financing sometimes puts the company into serious financial difficulties. Even a
slight rumour that the company is not doing well may result in a rush of the public to the
company for getting premature payments of the deposits made by them.

(iii)

The system may prove injurious for the growth of a healthy capital market. A heavy reliance on
public deposit for medium term financing by companies may adversely affect the supply of
industrial securities, particularly shares and debentures to general public.

4. Finance Companies
During the last ten years finance companies have assumed an important role in providing and arranging
finances for the industry in the following manner.
1. Leasing and Hire Purchase : Finance Companies help industry in acquisition of capital assets viz.
Plant and Machinery, Vehicles, Office Equipments through leasing or hire purchase facilities. Today
leasing and hire purchase are so prevalent as a mode of financing that have become sale aid tools
for the automobile and consumer electronics industry.

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2. Merchant Banking : With the liberalization of the capital market system and abolition of office of the
Controller of Capital Issues, it has become very attractive for the companies to raise long term
financial resources through capital market rather than depending on finances from financial
institutions and banks. Finance companies help the industry in this process by providing the
merchant banking services.
Merchant banking is basically a service banking, concerned with providing non-fund based services of
arranging funds rather than providing them. The merchant banker merely acts as an intermediary, whose
main job is to transfer capital from those who own it to those who need it. With the increase in the
complexities and requirements of modern business, the role of a merchant banker has undergone
substantial change. The merchant banker now acts as an institution which understands the requirements of
the entrepreneurs promoters on the one hand and financial institution, banks stock exchanges and money
markets on the other. The services of a merchant banker can be summarized as follows:
(1) Project counselling : A merchant banker helps an entrepreneur in conception of idea, identification
of projects, preparation of projects feasibility reports, fixing location, obtaining money, sanctions /
approvals from State and Central Government departments.
(2) Sponsor of issue: Merchant bankers act as sponsor of issue rather than sources of finance. They
prepare prospectus, get the approval from SEBI. Engage underwriters, brokers and bankers for
issue.
(3) Credit syndication: Merchant bankers undertake preparation of project files, loan applications for
financial assistance on behalf of poromoter from different financial institution for meetings long-term
as well as working capital requirements of their clients.
(4) Servicing of issues : Merchant bankers keep register of share holders and debentures holders of
their client companies, act as paying agents for the dividends, debentures interest. They also
arrange for safe custody of securities on behalf of their clients.
(5) Investment management : Merchant bankers render advice in matters pertaining to investment
decisions, effects on taxation and inflation of giltedged and other securities. They also undertake
the functions of buying and selling securities for their client companies.
(6) Arrangement for fixed deposit : Merchant bankers help companies to raise finance by way or
deposits from the public. For this purpose, they not only provide required guidance but also acts as
brokers for mobilization of public deposits.
(7) Other specialist activities : These include:
a. Corporate counselling for financial institutions, rehabilitation and reconstruction of old/ailing
or sick industrial units.
b. Services to NRIs for suitable investment opportunity in India.
c. Assistance in negotiations of foreign collaboration.
d. Arranging technology, finance and risk / venture capital.
Suitable fee is charged for such services by the bankers. The amount of fee will depend on the width and
range of services rendered.
In order to function as a merchant banker, one has to take authorization from the securities & exchange
Board of India (SEBI).

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As at the end of August, 1984, the total number of merchant bankers (of all categories) registered with
SEBI was 422.

3. Equity Research and Investment Counselling : A common investor is not able to apply his mind for
analysis of financial statement and future prospects of various companies for investment decisions.
In order to cater to the needs of such investors, many finance companies have established equity
research and investment counselling department. The department provides advisory services to
potential investors at a nominal cost and thus indirectly help the companies to raise resources.
5. Accrual Accounts
Accrual accounts are a spontaneous source of financing, since they are self generating. The most
common accrual accounts are wages and taxes. In both cases the amount becomes due but is not
paid immediately. Usually a date is fixed for payment, for example, wages are paid in the first week
of the month next ot the month in which the services were rendered. Similarly, a provision for tax is
created out of the profits of the company at the end of the financial year but the tax is paid only after
the assessment is finalized. Thus, the time lag between receipt of income and making payment for
the expenditure incurred in earning that income helps the business in meeting some of its shortterm financial requirements. Accrual accounts become an important source of finance since with
increase in scope of the operation of the business with increase in sales, labour cost usually
increase and with them the amount of accrued wages also increase. Similarly with increasing profits
the amount of accrued taxes also increases in almost in the same proportion and in the same
direction.
Merits
Financing through accruals is a costless or interest free source of financing. Services are rendered by the
employees but they are not paid not they expect to be paid until the end of the pay period. Similarly taxes
re not paid until their due date.
Demerits
An accrual account is not discretionary sources of financing; for example, the company cannot indefinitely
postpone the payment of taxes of the Government without attracting penalties. Similarly the trade unions
will also resent if the wages are not paid to the workers in time. Postponement of wages may also affect
the morale of the employee resulting in absenteeism reducing efficiency and higher labour turnover.
This source of financing should be resorted to only in the last. However, many companies on the brink of
cash insolvency find it a convenient remedy to save themselves by resorting to postponing payment of
wages and other expenses.
6. Indigenous Bankers
Indigenous bankers are private individual engaged in the business of financing small and local business
units. They provides short-term or medium-term finance. However, they charge exorbitant rates of interest
and are, therefore, considered only as a lat resort of finance.
7. Advances from Customers
Manufacturers and contractors engaged in producing or constructing costly good involve considerable
length of manufacturing or construction time usually demand advance money from their customers at the
time of accepting their orders for executing their contracts or supplying the goods. This is a cost-free

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source of finance and really useful in those businesses where it has become customary to receive advance
payment from the customers.

8. Miscellaneous Sources
A business firm may resort to miscellaneous sources of finance in periods of pressing needs. Such sources
may include loan from directors or sister business units. Specialized financial institutions also provide
short-term finance to their client units in times of need. The cost of these funds is usually nominal.

2. LONG TERM OR TERM LOANS

The term Term Loans is used for both medium as well as long-term loans. Medium terms loans are for
periods ranging from 1 to 5 years while long-term loans are for a period from 5 to 10 years. First the special
features of such loans and then the role played by different institutions in granting of such loans are
discusses.

Special features of term loans

1. Objective The term loans are granted for one or more of the following objectives:
(a) Establishment, renovation, expansion and modernization of industrial units.
(b) For meeting the requirements of the core working capital.
(c) For retiring bonds in order to reduce interest costs or to redeem preference shares so as to
substitute tax deductible interest payment for non-deductible dividends.
2. Security Terms loans are usually secured. They have either a fixed or floating charge against the
assets of the company. The lender bank usually prefers a first charge, however, in appropriate
cases it accepts a second charge also.
3. Time period The term loans are granted for a period ranging from 1 to 15 years but generally
from 8 to 15 years. The repayment is made in installments typically designed to fit the project
capacity of the borrower to pay. The repayment starts 2 or 3 years after sanctioning of loan. The
lending institution requires payment only in accordance with the specified schedule so long the
borrower carries out his commitments under the loan agreement. In case of default in such
commitment, the agreement provides for accelerating of the maturity of the loan.
4. Formal agreement The term loan is granted on the basis of a formal agreement. The agreement
contains the terms of granting loan and provides for certain protective clauses for the benefit of the
lender, e.g. limiting the dividend rate, the power to appoint directors, conversion of loan into share
capital, etc. Then terms are settled through direct negotiation between the borrower and the lending
institutions.
5. Participation basis- In case of term-loan being a substantial amount, different financial institutions
participate in the credit on a syndicated basis. Such participation is done either because restrictions
or for sharing the risk. The larger the loan, greater is the participation.
6. Introduces financial discipline Term loans introduce a proper financial discipline in the
borrower. He has to forecast reasonable accuracy cash flows so that he can repay loan and interest

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as per the agreed schedule. This makes necessary for the borrower to prepare a projected cash
flow statement.
7. Refinance facility Commercial banks are granted refinance facility from Industrial Development
Bank of India on the terms loans granted by them. The risk, of course, continues of the lending
commercial bank.
8. Project oriented approach Financial institution engaged in term lending do not do securityoriented lending any longer. They have detailed app of each project and asserts its own merits. The
loan is sanctioned only when the project satisfies their tests.
9. Special Conditions In order to provide safeguards against time and cost overruns the loan
agreements usually require the borrower to give undertaking in respect of the following matters :
(i)

No further long-term loan shall be taken

(ii)

The debt-equity ratio will not exceed the specified limit.

(iii)

Current ratio will be maintained at the desired level.

(iv)

Selling commission sole selling agent shall not be disbursed unless interest and installments of
loans are paid.

(v)

Dividend shall not be declared for a specific period or shall not exceed the agreed rate.

(vi)

Financial data and other information as required by the lending institution will be supplied as
and when desired.

(vii)

The directors will furnish personal guarantees for repayment of the loan in addition to the
financial institutions charge on firms assets.

Sources of Term Loans

There are two major sources of term loan : (i) Specified financial institutions or development banks and (ii)
Commercial banks. However, the former happens to be the main source of term-finance for all business
and industrial units. Each of these sources of finance have been explained in the following pages.
Sources of Term Finance
The major sources of term finance in India are as follows :
(1) Term Loans A term loan is a business loan with a maturity of more than one year. There are
exceptions to the rule, but ordinarily term loans are retained by systemic repayments over the life of
the loan. The primary lenders on term credit are Commercial banks, life insurance corporation,
financial institutions, general insurance companies, investment trusts and state and central
government. Commercial banks and various financial institutions constitute the hard core of term
financing in India. Term lending business of Commercial banks is recent innovation in India
specially after 1958. It was in the year of 1958 only when a formal scheme of term loans was
started. But, now-a-days these banks provide a larger share of tem finance to Indian Industries.
(2) Public Deposit Besides, commercial banks and institutional finance, the public deposits are also
important source of term finance. Till independence, this system was prevalent mainly in the cotton
textile industry of Bombay, Ahmedabad, and to some extent, that of Sholapur, and the tea gardens
of Assam and Bengal. But now-a-days this system has been very popular with all types of
companies and business. In January 75 the Reserve Bank of India issued news guidelines
regarding public deposits, since then, the method has gained more popularity. By renewal or getting

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initial deposits for 3 or 5 years at a lucrative rate of interest @ 12% - 15%, the companies have
been able to attract a large section of individuals savings towards them.
(3) Conditional Sales Contracts This system is also known as hire purchase or installment
purchasing system. Under this method, the industrial purchases machinery at deferred payment
basis. Some part of the price is paid at once at the time of delivery (it is known as cash-down
payment) and remaining part of the purchase price is paid in installments through a finance
company or a bank. Factory equipments hotel and restaurant fixtures, buses, tractors, and trailer,
medical equipments etc. are supplied by their manufactures generally on this basis. Such
conditional sale contact may be signed by the manufacturer and purchase of machinery and bank
can guarantee this payment. Sometimes, bank or financial institution becomes a party to this
contract.
(4) Lease Financing Business firms are generally interested in using fixed assets, not in owing
them, but on the basis of lease arrangement. Before 1950s lease system was particular with land,
buildings and mining only; but now it is possible to lease virtually all kinds of fixed assets today. A
lease contract takes several different forms, the most important of which are sale and leaseback,
service leases, and straight financial leases. Leasing has the advantages of a smaller down
payment and increased opportunities for tax savings, and it increases the over all availability of
non-equity financing to the firm.
(5) Internal Sources of Term Finance A company does not go in for external sources of funds every
time. But internal sources of funds are also used by them. Retained earnings, employees provident
fund and pension fund accumulations, provisions for depreciation etc. also constitute and important
source of internal term financing. These funds can be successfully utilized by the companies for
replacement, obsolescence, short-term expansion or medium-term financial requirements. During
the last five years in India, the business firms are relying upon internal sources more due to creditsqueeze by commercial banks and specially after the submission of Tandon Committee Report.

Term Lending
The primary task of a lending institution before granting a term loan is to assure itself that the anticipated
rise in the income of the borrowing units would materialize, thus providing the necessary funds for
repayment. The methods of analysis and appraisal of a term loan applications and standards to be adopted
for it are more similar to investment decision that to short-term lending. Appraisal of term-loan application
requires a dynamic approach involving inter-alia, a portion of future trends of output, sales, estimates of
costs, returns and flow in analyzing a term-loan proposal, emphasis is generally placed on the following :(1) Type and size of Business.
(2) The Record, character and continuity of Management
(3) General Record of the borrower (in respect of his product market, competition and general outlook
for that industry etc.)
(4) Operating Efficiency
(5) Financial conditions and projected balance-sheet etc.
(6) Estimations of future Earnings and cashflows.
(7) The available security

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In India, when an application for term loan is moved to a term lending institution, the borrower is required to
submit the following statement and papers along with the application :
(i)

Brief historical background of the project or plant.

(ii)

Details of promoters, if it is a new company.

(iii)

Latest audited Balance Sheet in case of an existing company.

(iv)

Existing manufacturing facilities.

(v)

A project feasibility Report

(vi)

Capacity calculations must be submitted separately in terms of 300 working days.

(vii)

Management set-up and particulars regarding management people.

(viii)

Promoters contribution to the Project cost normally it is acceptable upto 20% but relaxation is
possible for backward area locations, technical entrepreneurs projects and capital intensive
projects. But their contribution in any case shall not be less than 15%.

(ix)

The following annexures are a must with the application.

(1) Copy of letter addressed to the bankers authorizing them to disclose any information concerning
the applicant.
(2) Particulars of existing long-term borrowings.
(3) Particulars of existing shareholdings.
(4) Distribution of existing shareholders.
(5) Particulars of proposed buildings.
(6) Particulars of proposed machinery.
(7) Particulars of imported machinery.
(8) Raw material requirements.
(9) Estimates of the cost of project.
(10)

Calculation of contingency

(11)

Calculation of margin money for working capital.

(12)

Means of Financing

(13)

Proposal for raising share capital loans and debentures

(14)

Sources of funds in respect of expenditure already incurred.

(15)

Estimates of cost of capital.

(16)

Estimates of cost of production

(17)

Estimates of working capital

(18)

Estimates of production and sales.

(19)

Calculation of amount of wages and salaries at optimum production level.

(20)

Cashflow statements.

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(21)

Projected Balance Sheet

(22)

Break-even charts.

When an application is received by the financial institution its term lending section makes an appraisal of
the proposed project thoroughly. Each projects is assessed on its own merits. The declared objective of
such appraisal are threefold:
(1) The Financial Validity
(2) The Economic necessity (from the national economy point of view)
(3) The Technical Feasibility
Once the objectives are fixed, appraisal is just an intelligent application of the techniques of appraisal.

Specialized Financial Institutions or Development Banks

A large numbers of specialized financial institutions have been set up in the country after independence to
meet the specific term financial needs of industrial enterprises. They are popularly known as Development
Banks. A development bank is essentially a development catalyst. It seeks to mobilize scarce resources,
such as capital, technology, entrepreneurial and managerial talents and channelize them into industrial
activities in accordance with plan priorities. It has, therefore, to shape its policies, procedures, and
functions in a way so as to cater to development needs of specific sectors as well as the economy in
general. Some of such banks are as follows:

1. Industrial Finance Corporation of India (IFCI)

The corporation was set up in 1984 under an Act of Parliament to provide medium and long-term
financial assistance to industry. The Corporation can grant such assistance only to public limited
companies and co-operative societies. State-owned public limited companies can also obtain
assistance from the Corporation as per an announcement made by the Corporation in August 1970.
The corporation has been converted into a limited company from July 1993.
Resources of IFCI The original authorized capital of the Corporation was Rs. 20 crores. It was
increased to Rs. 100 crores by an amendment in 1982. In 1986 by another amendment, it has been
provided that the share capital of the Corporation can be raised to Rs. 250 crores as may be fixed by
the Central Government by notification from time to time. The paid-up share capital as on 31 st March,
1991, was Rs. 135 crores. The Corporation can also accept deposits from the public and borrow money
from RBI for augmenting its resources.
Management : The management of the Corporation vests in a Board of Directors appointed as follows:
No. of directors
Nominated by Central

Government
Nominal by Reserve Bank

Elected by Bank, Insurance Companies, Investment

6
Total

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The Board of Directors have delegated their powers to a committee of directors considering of five
member, one of whom is the Managing Director of the Corporation.

Functions The functions of the Corporation as given in the Act are as follows(i)

Guaranteeing loans raised by industrial concerns which are repayable with in a period not
exceeding 25 years and are floated in the public market.

(ii)

Underwriting of the issue of stocks, shares, bonds or debentures issued by industrial concerns.
However, they must be disposed of by the corporation within 7 years of their acquisition.

(iii)

Granting loans or advances to or subscribing to debentures of industrial concerns repayable

within a period not exceeding 25 years.

(iv)

Extending guarantee in respect of deferred payments by importers who are able to make such
arrangement with foreign manufactures.

(v)

Acting as the agent of the Central Government or for World Bank in respect of loans sanctioned
to the industrial concern.

(vi)

Undertaking financing of projects wit the Industrial Development Bank of India and other
financial institutions. Those would include guaranteeing loans raised by industrial concerns from
other financial institutions, the purchase of stock, shares, bonds and debentures from existing
holders, doing merchant banking operations, undertaking research to carry out technoeconomic studies in connection with industrial development etc.

The Corporation provides financial assistance for setting up new industrial projects, renovation,
modernization, expansion, diversification of existing ones. It also provided financial assistance on
concessional terms for setting up industrial projects in industrially less developed districts in the State and
Union Territories as may be notified by the Central Government.

Working of the Corporation Ever since its inception in 1948 till the end of March 1996, the total
sanctions and disbursements by IFCI amounted to Rs. 33,695 crores and Rs. 19,950 crores respectively.
As at the end of March 1996 total outstanding assistance stood at Rs. 12,751 crores.

2. State Financial Corporation

In order to provide financial assistance to small-scale industries and medium size industries, State
Finance Corporation Act was passed by Parliament in 1951. The act is applicable to all States except
the State of Jammu and Kashmir. Almost all the States have set up such Corporation.
The capital of such corporation has to be fixed by the State Government with the minimum and
maximum limits of Rs. 50 lakhs to Rs. 50 crores. The shares of the corporations are taken by
respective State Government, the Reserve Bank of India, scheduled banks, co-operative banks,
insurance companies, investment trust and private parties. The maximum allotment to private parties
cannot exceed 25% of the share capital of the corporation. The corporation can grant assistance
maximum assistance to a company / co-operative society that would not exceed Rs. 60 lakhs and to a
partnership or a sole proprietary firm Rs. 30 lakhs.Working The total assistance granted by 18 State
Financial Corporations (including Tamilnadu Industrial Investment Corporation Ltd. ) since their

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inception amounted Rs. 22,893 crores and disbursements at Rs. 17,952 crores as the end of March 31,
1996)

3. State Industrial Development Corporation (SIDCs)

State Industrial Development Corporation have been set up by different State Governments for
promoting industrial development in their respective States. As at the end of March 31, 1996 28 SIDCs,
since their inception, had sanctioned and disbursed financial assistance to the extent of Rs. 11,712
crores and Rs. 8,325 crores respectively.

4. Industrial Credit and Investment Corporation of India (ICICI)

The Corporation was established on January 5, 1955 to assist industrial enterprises in the private
sector. It started its operations as a wholly privately owned institution but with nationalization of the life
insurance business, the Life Insurance Corporation of India has become its major shareholder.
Objects: The objects of the corporation are to assist industrial enterprise in private sector by:
(i)

Granting secured loans in rupees repayable over a period of 15 years.

(ii)

Making similar loans in foreign currencies for payment of imported capital equipment and
technical service.

(iii)

Guaranteeing rupees payments for credit made by others.

(iv)

Subscribing to equity and preference shares directly and underwriting public and private issues
and offer to sale of industrial securities.

(v)

Furnishing technical and administrative assistance to Indian industry.

5. Industrial Development Bank of India (IDBI)

The IDBI was established in July 1964 under the Industrial Development Bank of India, Act as a wholly
owned subsidiary of the Reserve Bank of India. However, in February 1976, it was delinked from the
Reserve Bank and has emerged as an independent organization. It now serves as an apex financial
institution.
Resources : The principal resources of IDBI are : (i) Share capital and Reserves, (ii) borrowings from
the Government of India and RBI, (iii) Market borrowings by way of bonds, (iv) Foreign currency
borrowings, and (v) Repayment of past assistance by borrowers.
The Banks authorized share capital is Rs. 2,000 crores. The issued and paid up share capital as on
March 31, 1996, of the bank was Rs. 818.59 crores, largely held by the Central Government.
Management The IDBI has a board of directors appointed as follows:
(i)

A chairman and a Managing Director both appointed by the Central Government. However, the
same person may also function as chairman as well as Managing Director.

(ii)

A Deputy governor of the Reserve Bank of India is nominated by it.

(iii)

Not more than 20 directors nominated by the Central Government are as follows:
(a) Two directors who are the official of the Central Government.

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(b) Five directors from the financial institutions viz., ICICI, IFC, IDBI, LIC & UTI.
(c) Two directors amongst the employees of IDBI and the above mentioned financial institutions
one from the officer employees and the other from workmen employees.
(d) Six directors from the State Bank, nationalized banks and State Financial Corporation.
(e) Five directors having special knowledge and professional experience in science, technology,
economics, industrial co-operative, law, industrial finance, investment, accountancy,
marketing or any other matter useful to IDBI.

Objective and Functions : The main objective of IDBI is to serve as the apex institution for term-finance
for industry in India.
The Bank ha been assigned a special role in respect of the following matters:
(i)

Planning, promoting and developing industries to fill the gaps in the industrial structure in
India.

(ii)

Coordinating the working of institutions engaged in financing, promoting or developing

industries and assisting in the development of such institutions.

(iii)

Providing technical and administrative assistance for promotion, management or

expansion of industry, and

(iv)

Undertaking market and investment research and survey as also techno-economic

studies in connection with development of industry.

The Banks charter provides for considerable operational flexibility. IDBI can finance all types of industries
irrespective of the form of organization or size of the unit. Also there are no restriction on the nature and
type fo security and quantum of assistance which the Bank can provide.

Schemes of Assistance The schemes of assistance operated by the IDBI can broadly be divided into
two categories, viz., (i) Direct Assistance Schemes which include Project Finance Scheme, Technical
Development and Fund Scheme and Equipment Finance Scheme, etc. (ii) Indirect Assistance Schemes,
which includes Refinance of Industrial Loans Scheme, Bills Rediscounting Scheme, Seed Capital
Assitance Scheme and Resources Support Scheme.

Working of IDBI The cumulative sanctions by the IDBI up to 31 st March, 1996, under its various
schemes, since its inception, amounted to Rs. 1,14,811 crores while the disbursements amounted to Rs.
77,691 crore. Out of this direct assistance amounted to about 50.2% of the total sanctions.
The IDBI has recently decided to provide working capital loans also initially to those companies which have
taken term loan from it. IDBI has earmarked a sum of Rs. 2,500 crores for 1997-98 for this purpose.

6. Unit Trust of India (UTI)

UTI came into existence of February 1, 1964 under the Unit Trust of India Act, 1963. Its establishment has
been a landmark in the history of investment trusts in India.

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The initial capital of Rs. 5 crores was subscribed fully by the Reserve Bank of India (Rs. 2.5 crores), the
Life Insurance Corporation (Rs. 75 Lakhs), the State Bank of India, (Rs. 75 lakhs), and scheduled banks
and other financial institutions (Rs. 1 crore)
The general administration and management of UTI is vested in the Board of Trustees consisting of a
Chairman and nine other Trustees.
The objective of the Unit Trust is to stimulate and pool the savings of the middle andlow income groups and
to enable them to share the benefits and prosperity of the rapidly growing industrialization of the country.
As a result of an amendment in the UTI Act in 1986, the UTI is also assisting corporate sector through term
loans, underwriting direct subscription to share/debentures.
The above objective is achieved by the UTI through a three-fold approach:
(i)

By selling units of the Trust to as many investors as possible in the different parts of the country.

(ii)

By investing the ale proceeds of the units and also the initial capital fund of Rs. 3 crores in
industrial and corporate securities; and

(iii)

By paying dividends to those who have bought the units of the Trust.

Working : UTI is playing an important role in mobilizing savings of the community through sale of units
under the various schemes and channelizing them into corporate investments. Over the years is has
floated 35 schemes including two off-shore country funds to suit diverse investment needs of the investors.
Consequent upon amendment to the UTI Act, effective from April 23, 1986, UTI has been extending
assistance to the corporate sector by way of term loans, bills rediscounting, equipment leasing and hirepurchase financing. In June 1990, UTI set up the UTI Instituted of Capital Markets with a view of promote
advanced professional education, training and research in the fields of capital markets.
At the end of June 1996, the UTI had a UNIT capital of RS. 44,386 crores and reserves and funds of Rs.
9,186 crores. The cumulative sanctions and disbursement up to the end of March, 1996, to the corporate
sector, amounted to Rs. 43,328 crores and Rs. 32,291 crores respectively.

7. Industrial Reconstruction Bank of India (IRBI)

The Industrial Reconstruction Bank of India (IRBI) was established in 1985 under the Industrial
Reconstruction Bank of India Act. 1985, after reconstitution of the erstwhile Industrial Reconstruction
Corporation of India. It is the principal credit and reconstruction agency for rehabilitation of sick and closed
industrial units. It assists industrial concerns by granting loans and advances, underwriting of stocks,
shares, bonds and debentures and guarantees for loans/deferred payments. The range of its services
includes provision of infrastructural facilities, consultancy, managerial and merchant banking facilities and
making available machine and other equipment on lease or hire-purchase basis.
The Corporation has been converted into a company in January 1997 through a Presidential Ordinance.
Since its inception in April, 1971 (as ISRC) till the end of March, 1996 the cumulative sanctions and
disbursements amounted to Rs. 3,521 crores and Rs. 2,404 crores respectively.

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8. Small Industries Development Bank of India (SIDBI)

The small Industries Development Bank of India (SIDBI) has been set up under the Small Industries
Development Bank of India Act, 1990, passed by Parliament. SIDBI is intended to work as a principal
financial institution for the promotion, financing and development of industries in the small-scale sector. It is
also expected to coordinate the functions of the financial institutions, viz, State Financial Corporation, State
Small Industries Development Corporation, Scheduled Banks and State Co-operate Banks, etc. engaged
in the promotion financing and developing the small-scale industries.

Resources The resources of SIDBI mainly comprise contribution from Industrial Development Bank of
India (IDBI) in the form of loans and shares and may include market borrowings, short-term and long-term
funds from the RBI and loans from the Government of India.
The capital of the bank is Rs. 1,000 crores and paid-up capital as on 31 st March 1996 was Rs. 450 crores.
The capital of the bank is wholly subscribed by the IDBI.

Working The SIDBI commenced operations on April 2, 1990, by taking over the outstanding portfolio and
activities of IDBI pertaining to the SSI sector. The portfolio thus transferred to SIDBI aggregated Rs. 4,200
crores. The total sanctions and disbursements extended by SIDBI aggregated Rs. 4,200 crores. The total
sanctions and disbursements extended by SIDBI under its various scheme since its inception upto the end
of March, 1996 amounts to Rs. 19,026 crores respectively.

9. Commercial Banks
Term bending by commercial banks is a recent phenomenon, It is felt that the commercial banks could
not afford to lock up large funds in long term assets because it would affect their liquidity and would make it
difficult for them to meet the working capital needs oft trade and industry. However, since 1958, when
Refinance Corporation as established by RBI, the Reserve Bank of India was enger to recommend a
change in the attitude of commercial banks towards term lending because on the one hand it could boost
the profits of the lending banks and on the other hand enable the borrowing units to enjoy certainty of
having funds for a specified period irrespective of any change of the monetary policy. As a result of this, the
commercial banks have started taking interest in term-lending but on a very nominal scale. In May 1975
the Reserve Bank urged the commercial banks to step up their term-lending particularly in the following
areas.
(i)

Deferred export payments.

(ii)

Industries where a significant portion of the output is meant for export or where new potential for
export could be quickly built up.

(iii)

Industries having short gestation period particularly in the core sector and especially those
producing mass consumption goods.

(iv)

Agricultural sector.

(v)

Industries in the Industrially backward areas.

(vi)

Small-scale industries involving investment not exceeding Rs. 25,000

(vii)

Capital goods industries.

(viii)

Deferred payment arrangements for purchase of capital goods in the domestic market.

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Commercial banks can sanction term loans up to Rs. 50 crores for individual projects. The banking system
as a whole can now sanction term loans up to Rs. 200 crores for an individual projects.

10. Export Import Bank (EXIM Bank)

The EXIM Bank was set up on 1 st January 1982, for financing and promoting export and also for
coordinating working of other financial institutions engaged in the export-import financing. The bank
functions as an apex institution for assisting and supporting development of such financial institutions
which are engaged in financing export-import. It also takes promotional activities and provides counseling
services to persons connected with export import business.

Schemes of Assistance The various schemes of EXIM Bank are as follows:

(i)

Export bill re-discounting scheme : The EXIM Bank rediscounts exports bills of banks of a
period not exceeding 180 days.

(ii)

Re-finance of export credit : The EXIM Bank gives 100% refinance in respect of post-shipment
credit extended by bank to exporters for export of capital goods.

(iii)

Financial Assistance : The EXIM Bank grants terms loans in rupee to exporters for export of
plants, equipments, machinery and related services on deferred payment terms to importers
abroad, turnkey projects and constructions contracts.

(iv)

Overseas Investment Finance : The EXIM Bank finances the equity investment by Indian
promoters in joint ventures abroad.

(v)

Guarantees The EXIM Bank participates with commercial banks in the guarantees issued in
foreign currencies on behalf of Indian exporters, contractors in favour of overseas importers.

(vi)

Overseas Buyers Credit The EXIM Bank offers credit directly to the foreign buyers for import
of capital goods and turnkey projects from India.

(vii)

Advisory Services : EXIM Bank offers advisory services such as advising small scale
manufacturers on export markets and product areas and design financial packages for exportoriented industries in India.

Working of the Bank : The bank started its operations with effect from March 1, 1`982. Soon after its
establishment it took over the export loan and guarantee portfolio of Industrial Development Bank of India
(IDBI). The cumulative sanctions and disbursements as at the end of March 1996 amounted to Rs. 14,338
crores and Rs. 11,801 crores respectively.

Important Covenants incorporated in Long-term Loan Agreement

The Financial Institutions while granting long-term loans to borrowers incorporate certain covenants in the
loan agreement to protect their interest. These covenants basically relate to project implementation, loan
realization, special bank accounts, changes in contracts, insurance coverage etc. Some of the important
covenants which are generally incorporated by the lead financial institutions required the borrower as
follows:

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(i)

He shall promptly notify the lead institution of any proposed change in the nature or scope of the
project and of any event or condition which might materially or adversely affect or delay
completion of the projects or result in substantial over-run in the original estimates of costs. any
proposed change in the nature of scope of the project shall not be implemented or funds
committed therefore without the prior approval of the lead institution.

(ii)

He shall promptly inform the lead institution of the circumstances and conditions which are likely
to disable the borrow implementing the project or which are likely to delay its completion or
compel the borrowers to abandon the same.

(iii)

He shall furnish to the lead institution such reports as required by the lead institution.

(iv)

He shall obtain prior concurrence of the lead institution to any material modification or
cancellation of the borrowers agreements with is various suppliers.

(v)

He shall ensure proper maintenance of the property.

(vi)

He shall make alteration in memorandum of association and articles of association as desired

by lender.

(vii)

He shall facilitate appointment of lenders nominee director.

(viii)

He shall promptly inform the lead institution if it has notice of any application for winding up
having been made or any statutory notice of winding up under the provisions of the Companies
Act., 1956 or any other notice under any other Act or otherwise of any suit or other legal process
intended to be filled or initiated against the borrower and affecting the title of the properties of
the borrower or if a receiver is appointed of any of its properties or business or undertaking.

(ix)

He shall promptly inform the lead institution of any labour strikes, lock-outs, shutdown etc. or
other similar happenings likely to have an adverse effect on the borrowers profits or business
and of any material changes in the rate of production or sales of the borrower with an
explanation of the reason therefore.

(x)

He shall submit its duly audited accounts within prescribed period (generally six months) after
the close or its accounting year. In case statutory audit (if required) is not likely to be completed
during this period, the borrower shall get, its accounts audited by an independent firm of
Chartered Accountants and furnish the same to lead institution.

(xi)

He shall maintain records showing expenditure incurred on the project, disbursement of the
loans, progress of the project and the operations and financial conditions of the borrower and
such records shall be open to examination.

(xii)

He shall not create any subsidiary or permit any company to become its subsidiary.

(xiii)

He shall not undertake or permit any merger, consolidation, reorganization or amalgamation

scheme or compromise with its creditors or shareholders.

(xiv)

He shall not make any investments by way of deposits, loans, share capital etc., in any concern.

(xv)

He shall not carry on any general trading activity other than sale of its own product.

(xvi)

He shall not remove any person by whatever name called exercising substantial powers of
management of the affairs of the borrower at the time of execution of loan agreement without
the consent of lead institution.

(xvii)

He shall not undertake any new project, diversification, modernization or substantial expansion
of the project.

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(xviii) He shall not issue any debentures, raise any loans, accept deposits from public, issue equity or
preference capital, change its capital structure or create any change on its assets or give any
guarantee without prior approval of lead institution.
(xix)

He shall not pay any commission to its promoters, directors, managers or other persons for
furnishing guarantees, counter guarantees or indemnities or for undertaking any other liability in
connection with any financial assistance obtained for or by the borrower or in connection with
any obligation undertaken for or by the borrower for the purpose of projects.

(xx)

He shall not declare or pay divided to its shareholders during any financial year unless it has
paid all the dues to the lender.

(xxi)

He shall not repay any loan availed from any other party without the prior approval of the lead
institution. If for any reason, the borrower is required to repay any loan, it shall make
proportionate repayment to the lenders as well subject to such conditions as may be stipulated
by lender.

Significance of Covenants : The following is the significance of incorporating the above covenants in a
loan agreement.
(i)

They provide security of loan and their repayment in time.

(ii)

They bind the company to comply with the instructions of the lead institution in their operations.

(iii)

They authorize the term lending institution to appoint the nominee directors on the board of
borrowing company. The nominee directors have to keep a watch on the following activities of
the borrowing companies and take appropriate measures in public interest.
a. The financial performance of borrowing company;
b. Payment of dues to the institutions;
c. Payment of government dues viz., custom duty and other statutory dues. In case the
borrowing company feels that the demand is unjustified, the nominee directors should
satisfy them selves regarding prima facie reasonableness of the companys case.
d. Inter-corporate investments and sale of shares.
e. All significant purchase and sale of shares;
f.

Expenditure incurred by the company regarding awarding of contracts, purchasing and

selling or raw materials, finished goods, machinery etc.

(iv)

They see that the borrowing company makes use of the funds only for the purpose for which
such funds have been sanctioned.

(v)

They help the financial institutions in performing the development role consists with the national
priorities.
BRIDGE FINANCE

The term, Bridge Finance refers to the loans taken by firms, generally from commercial banks,
pending disbursement of term loans from financial institutions, viz., IDBI, IFCI, ICICI, etc. It may be
noted that there is a always a time gap between the date of sanctioning of a loan its disbursement by
the financial institution to the concerned borrowing firm. In order to prevent delay in starting their

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project, the firms arrange from the commercial banks short-term loans which are later on repaid as and
when term loan disbursements are received from the financial institutions.
The bridge finance is secured against mortgage of fixed properties and / or hypothecation of movable
properties of the borrowing firm. The rate of interest on such a finance is usually higher than that on
term loans.
LOAN SYNDICATION
Loan syndication involves commitments for term loans from the financial institutions and banks for
financing a particular project. In other words, in loan syndication, two or more financial institutions / banks
agree to finance a particular project. One of the institutions may become a lead institution and bring about
coordination in the financing arrangements of different financial institutions/ banks.
A loan syndication arrangement may be made in any of the following ways:

1. The borrower may directly make the loan application to a lead financial institution, which in turn gets
in touch with other financial institutions / banks interested in participating in the financial assistance
to the borrower. The advantage of such arrangement would be that the borrower would not have to
approach different financial institutions.
2. The borrower may approach a merchant bank to arrange for a loan syndication for him. The
merchant bank discusses the matter with the financial institution interested in workings as a lead
financial institution. The merchant bank submits a formal application to the financial institution for
the term loan. On receiving such an application the financial institution examines the proposal
before accepting it for loan syndication.
The steps involved in a loan syndication arrangement can be put as follows:
1. Preparation of the project report,
2. Preparation of loan applicaton,
3. Selection of the financial institution for loan syndication,
4. Receipt of sanction latter or letter or intent from the financial institution.
5. Compliance of the terms and conditions of the loan arrangement by the borrower,
6. Documentation, and
7. Disbursement of loan.
BOOK BUILDING
Book-building is a novel and growing concept in India. According to this concept, the issuing company is
required to tie up the issue amount by way of private placement. The issue price is not determined in
advance. It is determined by offer of potential investors about price which they may be willing to pay for the
new issue. In order to determine this price, the issuing company organizes road shows and various
advertisement companies. in course of this process the issue manager or book-builder notes the amounts
offered by various investors such as institutional investors, mutual funds, underwriters, foreign institutional
investors, etc. The price of the instrument (i.e. equity share, debenture or bond) is the weighted average
price at which the majority of the investors are willing to buy the instrument.
This can be understood with the following example.

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Example. X Ltd. issued bonds of Rs. 100 each amounting in all of Rs. 1,000 crores. If appointed Mr. Y as a
book runner / issue manager. He got the following information at which different investor were willing to
purchase the bonds.
Quoted Price per bond

Total Amount of Bonds

(in Rs. Crores)

P1

Rs 95

100

P2

98

500

P3

101

100

P4

100

200

P5

99

100

Amount of Bonds

Total

(in Rs.)

(in Rs.)

(p)

(w) (in Crores)

(pw) (Crores)

95

100

9,500

98

500

49,000

101

100

1,100

100

200

20,000

99

100

9,900

w1000 crores

pw 97,500

The issue price can not be calculated as follows:

Price (in Rs.)

pw
Issued Price based on Weighted Average ----------------w

97,500
----------- = Rs 97.50
1000

Book-building as a method of raising funds has been approved by SEBI w.e.f. Nov.1995. Of course, it has
been provided that this method can be used only when the issue exceeds Rs. 100 crores and one of the
lead managers to the issue has to be appointed as the book-runner to the issue.

Book building helps in evaluating the intrinsic worth of an instrument and the companys credibility in the
eyes of the investor. The company also gets firm commitments on the basis of which it can decide whether
to go or not to go for a particular issue of securities.

PROMOTERS CONTRIBUTION

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In order to ensure promoters interest in the project, financial institutional insist before financing a new
project or expansion of the plant that the promoter should also contribute minimum amount to be
contributed by the promoter is termed as Promoter Contribution. The financial institutions had earlier laid
down certain norms for such promoters contribution. However, these norms have recently undergone a
change due to Governments policy for encouraging entrepreneurs to reduce their dependence on
financial institutions and to raise funds from the capital markets. As a result, financial institutions not
stipulate a promoters contribution of around 30% of the project cost, although no specific guidelines have
been issued for the same.
The Securities Exchange Board of India (SEBI) has laid down the following norms for promoters
contribution in case of pubic issues.
The Securities Exchange Board India (SEBI) has laid down the following norms for promoters contribution
is case of public issues.
The Securities Exchange Board of India (SEBI) has laid down the following norms for promoters
contribution in case of public issues.

Size of capital
premium)

issue

(including

Capital issue size (Rs. in crores)

% of
promoters
500

1,000

2,500

On first 100 crores of issue

50

50

50

50

Next 200 crores

40

80

80

80

Next 300 crores

30

60

90

90

Balance issue amounts

15

--

60

285 (adjusted to
305)*

Total promoters Contribution

190

280

505 (adjuste to
525)*

Average Percentage Contribution

38%

28%

20.0%e

*Note : The last slab in the case of issue of Rs. 2,500 crore has to be adjusted so that the total contribution
by the promoters works out to 21% of the issue capital. In other words, the slab shall be calculated at the
rate of 16.05% so that the amount shall be Rs. 305 crores instead of Rs. 285.
NEW FINANCIAL INSTITUTIONS AND INSTRUMENTS
The Indian Capital Market especially in the eight has been undergoing tremendous changes to cater the
varied needs of capital of the various sectors of economy. Its growth and development has further been
facilitated by the policy measures taken by the Reserve Bank of India and the Government of India with the
objective of speeding up the tempo of institutionalization of savings and investment.

The new policy measures have facilitated by established of new financial institutions and also introduction
of innovative financial instruments as discussed below:

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1. NEW FINANCIAL INSTITUTIONS

The following are some of new financial institutions which have been recently setup for a fast growth of the
capital market:
1. Venture Capital Institutions
Concept of Venture Capital : Venture capital is a form of equity financing designed specially for
funding high risk and high reward projects. It not only plays an important role in financing hitechnology projects, but also helps to turn research and development projects into commercial
production. venture capital, besides financing the technology, is also involved in fostering the
growth and development of enterprises. In the western countries much of this capital is put behind
establishing technology and expanding business or is used to help the evolution of new
management teams.

Venture Funds in India : The venture fund or venture capital schemes is of recent origin in India. The
following are some of the institutions which have established venture funds in India.
(i)

Risk Capital Foundation of IFCI: The first venture fund in the name of Risk Capital Foundation
was sponsored by the Industrial Finance Corporation of India (IFCI) in March, 1975. It was
reconstituted as Risk capital and Technology Finance Corporation Limited (RCTC) in January,
1988. At present RCTC operates three schemes, viz., Risk Capital Scheme. Technology
Finance and Development Scheme and Venture Capital Unit Scheme. Under the first two
schemes, the Corporation provides supplementary assistance to new entrepreneurs particularly
technologies and professionals for promoting medium size industrial projects both in the form
of rupee loans and direct subscription to their share capital. while under he Venture Capital fund
of Rs. 30 crores. (Rs. 20 crores from IFCI and Rs. 10 crores form the World Bank) has been set
up in July, 1991. The aim of the scheme is to provide venture capital for potentially highly
profitable venture involving innovative product technology / service aimed at futuristic or new
markets.

The cumulative sanctions and disbursements under the schemes of RCTC at the end of 31 st March, 1993
amounted to Rs.. 71.1 crores and 48.5 crores respectively. A sizeable portion of the sanctions and
disbursements were in respect of risk capital scheme.
(2) Venture Fund of IDBI: The Industrial Development Bank of India (IDBI) also started venture capital
scheme in 1986. The cumulative sanctions and disbursements under the scheme since its inception
to the end of March, 1993 amounted to RS. 46.8 crores and Rs. 38.3 crores respectively.
(3) Venture Capital Fund of SIDBI : The Small Industries Development Bank of India (SIDBI) has also
set up a venture capital fund with an initial corpus of Rs. 10 crores during the year 1992-93. The
funds is exclusively meant for providing financial assistance for innovative venture in small-scale
sector.
(4) Venture Capital Fund of Technology Development and Infrastructure Corporation of India
(TDICI): The Corporation has been set up by Industrial Credit Investment Corporation of India
(ICICI) for providing technology information and financing commercial research and development
schemes. It also manages the venture capital fund of Rs. 30 crores which ICICI has established
along with UTI in 1988.
The cumulative sanctions and disbursements by TDICI as at the end of March, 1993 stood at Rs.
81.2 crores and Rs. 66.1 crores respectively.

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(5) Other Venture Capital Funds : Besides the public financial institutions (IDBI, IFCI, ICICI and
SIDBI), as discussed above, certain banks, viz., State Bank of India, has set up the venture capital
fund through its subsidiary SBI Capital Markets Limited. Canara Bank has also set up a venture
capital fund through its subsidiary CanBank Financial Services Limited. Grindlays Bank has also
launched India Investment Fund. The funds raised from abroad NRIs. It is going to provide venture
finance to suitable projects out of this fund.

In the private sector, the Credit Capital Corporation has set up the Credit Capital Venture Fund India Ltd.
The Corporation intends to involve multinational bodies like Asian Development Bank and Commonwealth
fund in its financing. Guidelines for Venture Capital Fund Companies. The Government of India
announces on November 25, 1989 certain guidelines regarding establishment and functioning of venture
capital funds companies. These guidelines are summarized below:

(1) Establishment : All India Public Sector Financial Institutions. State Bank of India and other
scheduled banks including foreign banks operating in India and the subsidiaries of the above would
be eligible to start Venture Capita Venture/Companies subject to such approval as may be required
from Reserve Bank of India in respect of banking companies. in all other cases approvals would be
given by the Development of Economic Affairs, Ministry of Finance or such authority as may be
nominated by the Government.
(2) Venture Capital Assistance : The assistance has to go mainly to enterprise where the risk
element is comparatively high due to technology involved being relatively new and /or the
entrepreneur being relatively new and not affluent through otherwise qualified. The total investment
in the enterprise should not exceed Rs. 10 crores.
(3) Size : The minimum size of Venture Capital Company / Fund would be Rs. 10 crores. If it desired to
raise funds from the public, the promoters share shall not be less than 40%. The debt-equity ratio
may be maximum 1:1:5.

2. Mutual Funds
A number of banking companies and some financial institutions have, by forming separate subsidiaries,
started mutual funds. Such a mutual fund company invests the pooled funds of many shareholders
and thus give them the benefit of diversified investment portfolio. Mutual funds can be classified into
two categories :
(1) Open end Mutual Funds: In case of these funds, the fund itself is ready to buy back the shares
surrendered and sell new shares. Thus, there is not fixed number of outstanding shares. Ordinarily
the transaction of purchase of sale is made at the net assets value calculated every now and then.
The repurchase price is usually slightly lower than the selling price. The net assets value of the
mutual fund increases or decreases depending up on the mutual fund. Most of the mutual funds
started by the commercial banks in over country fall in this category.
(2) Close end Mutual Funds: In case of these funds, the mutual fund management sells a limited
number of shares. It does not stand ready to redeem or repurchases these shares. Primary
example of such a mutual fund is UTI master share. The shares of such a mutual fund are
purchased and sold in the secondary markets.

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Several commercial banks in India have recently entered inot the fields of mutual funds, viz., SBI Mutual
Fund- management, Canshare Fund or Canstock Fund or Canara Bank, Swarnpushpa Mutual Fund of
Indian Bank, Boi Mutual Fund of Bank of India etc. Besided ITI, GIC, Life Insurance Corporation of India
have also entered this area. Some other banks are also likely to enter this market.
The mutual fund scheme offers the advantages of high return, easy liquidity, safety and tax benefits to the
investment while it offers the bank an opportunity to collect funds from untapped areas.
Of course, the entry of commercial banks in the field of mutual fund has ended the monopoly if UTI and LIC
and helped in providing stability to the stock market. However, their entry can be justified only when the
mutual fund schemes succeed in mobilizing additional savings and investing them as per national priorities.
Commercial banks have the advantages of having a large number of branches in rural areas. it is,
therefore, hoped that their initiation of mutual fund schemes will benefit a large majority of rural populations
and not only a small privileged minority living the urban areas.

3. Factoring Institutions
Concept : Factoring service has gained strong momentum in advanced countries of the West. Initially,
the factoring was considered to be a financial service under which the factor usually a bank undertook
collection of clients debts, and finance the client on the basis of his accounts receivable.
However, the scope of factoring in modern times has considerably increased. It is a continue service
arrangement under which a financial institution undertakes the task of recording, collecting, controlling
and protecting the book debts for is clients including the purchase of hi bill or receivable. Thus, as a
result of factoring services, the manufacturer, seller or dealer in goods can concentrate on
manufacturing, advertising and selling functions alone, the record-keeping functions of sales, book,
debts, bill receivable and their utilization are completely vested with the factoring agency. The is result
in the following major benefits to the client:

(i)

Reduction in the cost of maintenance and collection of book debts;

(ii)

Saving in time, man-power etc., needed for collection; and

(iii)

Monitoring of book debts and prevention of bad debts since the debentures would not like to be
looked down in the eyes of factoring credits institution.

Functions : The functions of a factoring credit institution can be grouped into the following categories:

(i)

Credit recording: It involves maintenance of debtors ledger, collection schedules, discount

allowed schedule, ascertainment of balance due, etc.

(ii)

Credit administration: It includes the work of collecting the book debts. The factoring institution
receives service charges by way of discount or rebate deducted from the bill or bills.

(iii)

Credit protection: The factoring institution eliminates the risk of loss of the client by taking over
the responsibility of book debts due to the client.

(iv)

Credit financing: The factoring institution advances appropriation of the value of book debts of
the clients immediately, and the balance on maturity of book debts. This improves the clients
liquidity position in the sense that book debts have been substituted by cash.

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(v)

Finance and business information. A factoring institution also advice the client on the prevailing
business trend, financial and fiscal policy, impending development in commercial and industrial
sector, potentials for foreign collaboration, transfer of technology, export and import potential,
identification and selection of potential trade debtors, etc.

Thus, factoring service is more than simply a method of business finance. The Reserve Bank of India has
initiated several measures to develop factoring service. It appointed a working group popularly known as
Voghul committee to explore the possibility of encouraging the factoring service for collection of dues and
book debts on behalf of the suppliers. The committee recommended in its report in 1987 for introduction of
factoring service in the country. It advised banks as well as private non-banking financial institution to
develop factoring service. As a follow up measure, the RBI on January 19, 1998 constituted a Study Group
under chairman ship of Shri Kalyan Sundaram to examine the feasibility and mechanism of starting
factoring services.
As a result of the recommendations of the above group, the Government of India notified factoring is an
eligible activity for the banking.
At present there are two factoring companies operating in India, viz., SBI Factors & Commercial Services
Pvt. Ltd., a subsidiary of State Bank of India and Canbank Factors Ltd., a subsidiary of Canara Bank. While
the SBI Factors with its corporate office at Bombay has jurisdiction over Maharashtra, Gujarat, Madhya
Pradesh and Goa States, Diu and Daman Union Teritory. Canbank factors with is corporate office at
Bangalore has jurisdiction over the southern States.
We are explaining below the details of the factoring services undertaken by SBI.

Factoring Services by State Bank of India

The first factoring service in India was launched with from September 1, 1991 by the State Bank of India, in
collaboration with Small Scale Industries Development Bank of India (SIDBI) and some other commercial
banks. These institutions have together launched a new company called SBI Factors and Commercial
Services Ltd. A brief description of the institution and its functioning is given below:
1. Share Capital :The company has a subscribed share capital of Rs. 25 crores. The share capital is
held by the State Bank of India 54%, SIDBI 20% State Bank of Saurashtra 10%; Union Bank of
India 10% and State Bank of Indore 6%.
2. Working Procedure : The working procedure involved in the factoring services can be summarized
as follows:
a. The supplier invoices his customers in the usual way only adding the notification that the
debt due on the invoice is assigned to and must be paid to the SBI factors.
b. The supplier offers assigned invoices to SBI factors with a schedule of offer accompanied by
the receipted delivery challans.
c. The SBI factor provide pre-payment to the supplier up to 80% of the invoice value. it also
performs the accounting function of sales ledger maintenance and collection function of
realizing invoices purchased.
d. The SBI factors sends on official notification and personalized statement of accounts of
different customers of the supplier.
e. On receipt of payment from the customer, the SBI factors pay the remaining 20% of the
invoices value to the supplier.

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f.

In order to keep the supplier informed of the factors invoices, the SBI factors send monthly
statement of accounts to the supplier.

The greatest benefit of the factoring services to the supplier is he can convert his invoice into instant
cash upto 80% of his value without having to wait for the usual 30 or more credit days.

3. Service Fee. : A service fee is levied for the work involved in maintaining sales ledger and collection
of the debts on the invoices. It will be calculated as a percentage of the gross value of the invoices
factored, based on (a) the gross sales volume, (b) the number of customer, (c) the number of
invoices and credit notes, and (d) work involved in collection. The service fee will range between
two and five percent of the gross value of the invoices.
4. Credit Rating Institutions
Concept : The concept of credit rating originated in the USA. The primary objective ofcredit rating is to
provide guidance to investors/creditors in determining the credit risk associated with a debt instrument/
credit obligation by and independent professional and impartial institution. At present there are a few credit
rating institution in the country. These include (i) Credit Rating information and Services India Limited
(CRISIL), (ii) Investment Information and Credit Rating Agency of India Limited (ICRA), (iii) Onida
Information and Credit Rating Agency of India Limited (ONICRA) and, (iv) Credit Analysis & Research
Limited (CARE). We are giving below briefly the details about each of these institutions.

(a) ONICRA : It was set up in 1993 by the Onida Group for assessing the credit worthness of the
individuals seeking finance for purchase of consumer durables or trade credits.

(b) Credit Analysis & Research Ltd. : CARE was also set up in 1993 by IDBI in collaboration
withsome banks and financial services companies. as on March 31, 1996 the number of cumulative
credit rating assignments completed by CARE stood at 484 of which 445 related to debt
instruments for a total debt of Rs. 23,638.

(c) Credit Rating Information & Services of India (CRISIL) : The Credit Rating Information &
Services of India Limited (CRISIL) was set up by the financial institution on January 19, 1998, to
facilitate the processing of proposals and giving of approvals by the SEBI for companies going to
the public for raising funds through issue of securities.
Share Capital : CRISIL has a capital base of Rs. 4 crores.
Functions: CRISIL has proved to be a boon to both companies and investors through its following
functions:
(i)

It provides an independent and unbiased report about the creditworthiness of company. Thus, it
enables it to mobilize directly savings from individuals at reasonable cost.

(ii)

It provides reliable financial information and increased disclosure to investors. Thus, it enables
them to buy securities with confidence.

Working: At present CRISIL is restricting its rating only to debt instruments, viz., fixed deposits,
debentures, and debenture portion of equity linked debentures. There is no compulsion for any
company to obtain or publicize the rating obtained from CRISIL. However, once credit rating is made
compulsory by the Government. CRISIL is planning to undertake credit rating of all types of securities.

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CRISIL has to evaluate and monitor the performance of a company through use of qualitative as well
as quantitative criteria for evaluation. The qualitative criteria include the companys competitive
position, its strengths and weakness, its management and business strategies, etc. while the
quantitative criteria include the financial statements the accounting ratios, the cash flow and funds flow
statements of the company concerned.

Progress of CRISIL, Since its inception till March 31, 1996, CRISIL has so far completed rating of
1,736 issues consisting of various types of debt Rs. 1,14,873 crores. Some of the companies which
have used CRISIL rating are Indian Petro Chemicals Limited (IPCL), Sundaram Fiannce Limited (SFL),
Mahindra Engine Steel Company Limited, Mukand Oil & Steel works Limited, Kirloskar Bros. Limited,
Municipal Bonds of Ahmedabad Municipal Corporation etc. During the year 1992-94 CRISIL launched
the RATINGDIGEST, which is a compilation in five volumes of CRISIL Rating Reports organized by
industries categories. In 1995 96 it introduced CRISIL 500 Equity Index.
Credit rating analysis is relatively, new development in India. It is expected that establishment of CRISIL,
will provide a strong impetus to the systematic risk evaluation of specified corporate instruments as well as
the companies issuing them.
(a) ICRA Ltd. ICRA formally known as the investment Information & Credit Rating Agency of India
(ICRA) was promoted by the Industrial Finance Corporation of India (IFCI). It was incorporated on
Jan. 16, 1991 as public limited company and started functioning with effect from September 1,
1991.
The ICRA also performs credit rating functions and finalizes its rating norms and standards in
consultation with Credit Rating Information & Services of India Ltd. (CRISIL) ICR A has an authorized
Capital of Rs. 10 crores. Industrial Finance Corporation of India (IFCI), Unit Trust of India, Life
Insurance Corporation of India, General Insurance Corporation of India, Housing Development Finance
Corporation of India, Infrastructure Leasing and Financial Services, State Bank of India, and 17
commercial banks are its shareholders.
Progress of ICRA, Since its inception till end of March, 1996 ICRA has rated 778 debt instruments
involving an amount of Rs. 93,380.
The Government has already announced compulsory rating for all debentures end bonds expect the
following :
1. Issue of non-convertible debentures upto Rs. 5 crores on private placement basis including with
mutual funds.
2. All issues of fully convertible into equity shares within 18 months from the date of issue at per
determined price.
3. Public sector bonds and private placement of debentures with financial institutions banks.
In the above cases, obtaining credit rating by the concerned company / institution is optimal. However,
where rating is required it is also obligatory for the concerned company to announce the result of rating.

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UNIT VIII
WORKING CAPITAL MANAGEMENT
Concept of Working Capital
Like the broader concept of capital, there is no universally accepted definition of working capital. As Gilbert
Harold puts this problem, Unfortunately there is so much disagreement among financiers, accountants,
businessmen and economists as to the exact meaning of the term working capital. it is quite true. Various
financial theorists have used this term in a number of ways. Some explain it in a narrow sense while some
others in a very wide sense. In narrow sense, some authorities define the term as the difference between
current assets and current liabilities. Other writers think of working capital as being equal to the total of the
current assets. On the other hand, some writers like Gerstenberg are not ready to call it as working
capital. They prefer to all it as Circulating Capital so we shall have to go through the various concepts of
working capital before reaching at any conclusion.

Definitions of working Capital

In the broad sense, the term working capital is used to denote the total current assets. The following are
some definitions of this group.

(1) Working Capital means current assets.

-

Mead Baker Malott.

(2) The sum of the current assets is the working capital of a business.
-

J.S. Mill.

(3) Any acquisition of funds which increases the current assets increase working capital also, for they
are one and the same.
-

Bonneville

(4) Working capital refers to a firms investment in short-term assets cash, short-term securities,
accounts receivable and inventories.
-

Weston & Brigham

In the narrow sense, the working capital is regarded as the excess of current assets over current
liabilities. This is the definition used by most financial experts and authors emphasizing the accounting
phase of finance. They include the name of E.E. Lincoln, E.A. Saliers, and C.W. Gerstenberg etc.
Gerstenberg defines it as follows : It has ordinarily been defined as the excess of current assets over
current liabilities.
Thus we see there is no difference in authorities over the true concept of working capital. the true
difference is on it quantity. The total current assets minus current liabilities approach refers to net
working capital. the total current assets approach has a broader application and it is more inviting to the
financial management. It takes into consideration all the current resources of the enterprise, from
whatever source derived and their application to the current and future activities of the enterprise. In the
words of Walker and Bauglin. A good current ratio may mean a good umbrella for creditors against
rainy day, but to the management it reflects and financial planning or presence of ideal assets or over

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capitalisation. Actually speaking, a successful financial executive is interested not in maintaining a

good current ratio but in maintaining an adjustable account assets so that the business may operate
smoothly. Thats if the term working capital is used without future qualification, it generally refers to the
gross working capital.

Kinds of Working Capital

Working capital can be classified on the basis of its composition. Thus, we can have gross working
capital comprising current assets and net working capital representing current assets minus current
liabilities. From the viewpoint of the finance manager this basis of classification is helpful since it
categories the various areas of financial responsibility. For instance, funds invested in cash, inventories
and receivable require careful planning and control if the firm is to maximize its return on investment.
While the above classification is very significant to the financial management, it is not completely
adequate as it does not mention about time. Time is an important variable which influences pattern of
financing working capital requirements. Using times as a basis, working capital may be categorized as
permanent and variable working capital.
Permanent working capital represents current assets required on a continuous basis over the entire
year. A manufacturing enterprise has to carry irreducible minimum amount of inventories necessary to
ensure continued production and sales. Likewise, some amount of funds lie tied in receivables where
the firm sells goods on credit terms. Some amount of cash has also to be held by the firm so as a to
exploit business fluctuations. Thus, minimum amount of current assets which firm has to hold for all the
time to come to carry on operations at any time is termed as permanent or regular working capital. It
represents hare core of the working capital. permanent working capital changes constantly its form
from one asset to another whereas fixed assets retain their form over a long period of time. Further,
fund of value representing permanent working capital never leaves the business process and therefore,
the suppliers should not expect its return until the business ceases to exit. Finally, permanent working
capital will tend to expand so long as the firm experiences growth in its operation.
Over and above permanent working capital, the firm may need additional current assets temporarily to
satisfy seasonal/cyclical demands. Thus, for example, added inventory must be held to support the
peak selling periods. Receivable increase following periods of high sale. Extra cash may be need to
pay for additional supplies following expansion in business activity. Similarly, in periods of dull business
conditions when most of the produce remains held in stock due to precipitate fall in demand, the
company would require additional cash to tide over the crises. Excess amount of working capital may
be carried to face cut-throat competition or any other contingencies like strikes and lockouts.
This additional amount of working capital represents variable or temporary working capital, size of
which depends upon changes in levels of production and sales resulting from changes in market
conditions. Funds requirements for this purpose are of short duration.

Importance of Working Capital

Working Capital is just like the heart of business. If it becomes weak, the business can hardly prosper
and survive. It is an index of the solvency of a concern. Its proper circulation provides to the business
the right account of cash to maintain regular flow of its operations. The following are the some worth
mentioning advantages of maintaining an ample working capital fund in the business.-

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(1) Cash Discount If proper cash balance is maintained, the business can avail of the cash
discounts facilities offered to it by the suppliers.
(2) Liquidity and Solvency The proper administration of working Capital enhances the liquidity in
funds and solvency and credit worthiness of the concern.
(3) Meeting unseen Contingencies It Provides Funds for unseen emergencies so that a business
can successfully said through the periods of crisis.
(4) High Morale The provision of adequate working capital improves the morale of the executive and
their efficiency reaches it highest climax.
(5) Good Bank Relations Good relations with banks can also be maintained. The enterprise by
maintaining an adequate amount of working capital is able to maintain a sound bank credit,
trade credit and can escape insolvency.
(6) Fixed Assets Efficiency Incurred Fixed assets of the firm also can not work without proper
amount of working capital. without it, fixed assets are like guns which can not shoot as there are
no cartridges.
(7) Research and Innovation Programmes No research programme, innovation and technical
developments are possible to undertake without sufficient among of working capital.
(8) Expansion Facilitated The expansion programme of a firm is highly successful, if it is financed
through own working capital.
(9) Profitability Increased The profitability of a concern also depends, in no small measure, on the
right proportion of fixed assets and current assets. Every activity of the business directly or
indirectly affects the current position of the enterprise hence its needs should be properly
estimated and calculated.
Thus the need for maintain an adequate working capital can hardly be questioned. Just as circulation of
blood is very necessary in the human body to maintain life, smooth flow of funds is very necessary to
maintain the health of the enterprise. The importance of working capital can be very well explained in the
words of Husband and Dockery : The price object of management is to make a profit. Whether or not this
accomplished in most business depends largely on the manner in which the working capital is
administered.

Determinants of Working Capital (The amount of working capital)

There are numerous factors which affect the working capital of a concern, the appraisal of which assets
management in formulating its policies and estimating its prospective requirements. The important factors
are as follows:
(1)

Nature of Business The effect of the general nature of the business on the working capital
requirements can not be exaggerated. Rail roads, and other, public utility services have large
fixed investment, so they have the lower requirements for current assets. Industrial and
manufacturing enterprises on the other hand, generally required a large amount of working
capital. A rapid turnover of capital (sales divided by total assets) will inevitably meant a larger
proportion of current assets.

(2)

Production Policies The nature of production policy also exercises its impact on capital
needs. Strong seasonal movement have special workings capital problems and requirements. A
high level production plan also involves higher investment in working capital.

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(3)

The proportion of the cost of Raw Materials to Total Costs In those industries where cost
of materials is a large proportion of the total cost of the goods produced or where costly raw
material is used, requirements of working capital will be rather large. But if the importance of
raw materials is small, the requirements of working capital will naturally be small.

(4)

Length of period of manufacture The time which elapses between the commencement and
end of the manufacturing process has an important being upon the requirements of working
capital. if it takes long to manufacture the finished project, naturally a large sum of money will
have to be kept invested in the form of working capital.

(5)

Rapidity of Turnover Turnover represents the speed with which the working capital is
recovered by the sale of goods. In certain business, sales are made quickly so that stocks are
soon exhausted and new purchases have to be made. In this manner, a small sum of money
invested in stocks will result in sales of a much large amount. It will reduce the requirements of
more working capital.

(6)

Terms of Purchases If continuous credit is allowed by supplier, payment can be postponed

for some time and can be made out of the sale proceeds of the goods produced. In such a case
the requirements of working capital will be reduced. The period of credit received and allowed
also determines the working capital requirements of the enterprise.

(7)

Growth with Expansion of Business As a company gross, it is logical to except the larger
amount of working capital will be required. Growing concerns require more working capital than
those that are static. The requirement of working capital also varies with economic
circumstances and corporate practices.

(8)

Business Cycles Requirements of working capital also very with the business cycles. When
the price level is up due to boom conditions, he inflationary conditions create demand for more
working capital. During depression also a heavy amount of working capital is needed due to the
inventories being locked unsold and book debts uncollected.

(9)

Requirements of Cash The working capital requirements of a company is also influenced by

the amount of cash required by it for various purposes. The greater the requirements of cash,
the higher will be the working capital costs of the company.

(10)

Dividend Policy of the Concern If conservative divided policy is followed by the

management the needs of working capital can be met with the retained earnings. Often
variations in need, of working capital bring about an adjustment of dividend policy. The
relationship between divided policy and working capital is well established and mostly
companies declare divided after careful study of cash requirements.

(11)

Other Factors In addition to the above considerations there are a number of other factors
affecting the requirements of working capital, for example, lack of co-ordination in production
and distribution policies, the fiscal and tariff policies of the government etc.

A prudent financial manager is always manger is always interested in obtaining the correct amount of the
working capital at the right time, at a reasonable cost at the best possible favourable terms. To adopt the
right sources it is very necessary for him to have a through understanding of the firms short-term funds
needs, market for short-term funds, required level of liquidity in funds and risk assumption. A firm interested
to obtain short-term funds has a choice of securing finance from alternative sources internal as well as
external. In making any final choice as regards to sources of working capital the relative cost of financing,
dependability upon the source and flexibility in financial planning must be given due weightgae.

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Sources of Working Capital :

The following chart gives a snapshot view of various sources of working capital available for a firm:

Working Capital Sources

Long term Sources

Short term sources

1. Sale of shares
2. Sale of debentures
Internal
3. Ploughing
profits

back

of

1. Depreciation funds

1. Trade Credit

2. Provision for taxation

2. Credit papers

3. Accrued expenses

3. Bank credit

4. Sale of idle fixed

4. Public deposits

5. Long-term loans

5. Customers credit
6. Govt. Assistance
7. Loans from Directors etc.
8. Security of Employees
9. Factoring

Financing of Long-tem working Capital

The long-term working capital requirements include the initial working capital and the regular working
capital. along with it, the minimum level of investment in various current assets also determines the
requirement of long-term working capital. This capital can be conveniently financed by the following
sources
(1) Share Capital A part of long-term working capital can be financed with the share capital.
(2) Sale of Debentures Debentures are also an important source of long-tern working capital
because they are fixed cost sources. Rights Debentures have also been very popular in India since
1978.
(3) Ploughing back of profits A part of the earned profits may be ploughed back by the firm in
meeting their working capital requirements. It is regular and cheapest sources of working capital as
it does not involve any explicit cost of capital.
(4) Sale of Fixed Assets Any idle fixed asset can be sold out and sale proceeds can be utilized for
financing the working capital requirements.
(5) Term Loans - The loans raised for a period varying from 3 to 5-7 years are also important
sources for working capital. this type of finance is ordinarily repayable in installments. Such loan
usually increases the working capital of the enterprises.

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Financing of short-term Working Capital

This category of funds covers the need of working capital for financing day-to-day business requirements.
Normally, the duration of such requirements does not exceed beyond a year. The sources of short-term
working capital may be internal as well as external.
(a) Internal Sources
(1) Depreciation Funds The depreciation funds constitute important source for working capital.
some authors of business finance do not accept them as a source of funds but it is not reasonable.
(2) Provision for Taxation The provisions for taxation can also be used by the companies as a
source of working capital during the intermitant periods.
(3) Accrued Expenses The firm can postpone the payment of expanses for short periods. Hence
these accrued expenses also constitute an important source of working capital.

(b) External Sources

(1) Trade Credit One of the most important forms of short term finance is the trade credit extended
by one business enterprise to another on the purchase and sale of goods and equipment. The use
of trade credit has increased in recent years due mainly perhaps to the credit squeeze. The trade
credit may also assume three forms :purchase on open account, purchasing on furnishing a
pronote for specified period and purchase on trade acceptance (i.e. bills payable)
(2) Bank Credit Commercial banks are also principal source of working capital. they provided
working capital in a number of ways such as overdrafts, cash credits, line of credit, short term loans
etc. Compared with other methods of borrowing this is the most flexible source because when the
debt is no longer required it can be quickly and early reduced. It is also comparatively cheap.
(3) Credit Papers In the category of credit papers, bills of exchange and promissory notes of shorter
duration varying between a month and six months are used. These papers are discounted with a
bank and capital can be arranged. Accommodation bills is an important method of such finance.
(4) Public Deposit Public deposits are also an important source of shot-term and medium term
finance. Due to shortages of bank credit in recent past, the importance of public deposits has
increased. They have been very popular among Indian companies during last three years.
(5) Customers Credit Advances may also be obtained on contracts entered into by the enterprise.
The customers are often asked to make some advance payment in cash in lieu of a contract to
purchase. Such advance can be utilized in purchasing raw material paying wages and so on.
(6) Governmental Assistance Sometimes, central and state governments also provide short-term
finance on easy terms.
(7) Loans from Directors etc. An enterprise can also obtain loans from it officers, directors,
managing directors etc. These loans are often obtained at almost negligible rates of interest. Some
times, no interest is charges on them. Loans an also to obtained from other fellow companies
working within the same group.
(8) Security of Employee - If employees are required to make deposits with their employer
companies, such companies can utilize those amounts in meeting their working capital needs.

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(9) Factoring Factoring involves raising funds on the security of the companys debts, so that cash is
received earlier than it the company waited of the debtors to pay. Thus the factors help in improving
the companys liquidity position. But this finance is not cheap in comparison to bank credit etc.
The forecast of working capital requirements of a concern is not an easy job. The concept of working
capital is closely related to that current assets. So, some experts of finance suggest that in estimations the
working capital requirements, the total current assets requirement should be forecasted. But, however, is
contention is not justified on logic as the short term needs of the funds are equally vitally affected by the
nature and composition of fixed assets. Hence, the problem of working capital forecast should be dealt
within the overall financial requirements of the concern.

Forecasting Techniques of Working Capital

If the working capital is to be estimated for the ensuring year, then the current requirements of the assets
and cash flow for that period are to be estimated. The study of cash flow will reveal how much cash is
available to meet the current assets requirements. The basic object of forecasting working capital needs is
either to measure the cash position of the enterprise or to exercise control over the liquidity position of the
concern. But, the circular flow of working capital does not occur automatically and it is the essential
responsibility of management to guide it in proper proportions through the production machine.
There are three popular methods available for forecasting working capital requirements:
(b) Cash Forecasting Method In this method the position of cash at the end of the period is shown
after considering the receipts and payments to be made during that period. Its form assuring more
or less a summary of cashbook. This shows the deficiency or surplus of cash at the definite point of
time.
(c) The Balance Sheet Method In the balance sheet method of forecasting, a forecast it made of the
various assets and liabilities of the business. Afterwards, the difference between the two is taken
which will indicate either cash surplus or cash deficiency.
(d) Profit and Loss Adjustment Method Under this method the forecasted profits are adjusted after
adding the cash inflow and deducting the cash outflows. The basic idea under method is to adjust
the estimated profits on cash basis.
A forecast of working capital requirements can also be called a working capital budget. The main object of
preparing a working capital budget is to source an effective utilization of the investment in current assets. It
shows the behaviour of working capital with the volume of output or estimated sales.
Estimating Working Capital Requirements
In order to determine the amount of working capital needed by a firm, a number of factors viz. Production
policies, nature of business, length of manufacturing process, credit policy, rapidity of turn-over, seasonal
fluctuation, etc. are to be considered by the Financial Manager. Besides this a Finance Manager can apply
any of the following techniques for assessing the working capital requirement of a firm.
Techniques for assessment of Working Capital Requirements. Following is a brief explanation for the
various techniques for assessment of a firms working Capital requirements.

1. Estimation of Components of Working Method : Since Working capital is the excess of current
assets over current liabilities, an assessment of the working capital requirements can be made by

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estimating the amounts of different constituents of working capital e.g., inventories, accounts
receivable, cash, accounts payable etc.
2. Percent of Sales Method: This is a traditional and simple method of estimating working capital
requirements. According to this method, on the basis of pas experience between sales and working
capital requirements, a ratio can be determined for estimating the working capital requirements in
future. For example, if the past experience show that working capital has been 30% of sales and its
is estimated that the sales for the next year would amount to Rs. One lack, the amount of working
capital requirement can be assessed as Rs. 30,00
The basic criticism of this method that it presumes a linear relationship between sales and working
capital. This is not true in all cases san method is nto universally accepted.
3. Operating Cycle Approach : According to this approach, the requirements of working capital
depends upon the operating cycle of the business. The operating cycle begins with the acquisition
of raw materials and ends with the collection of receivables. It may be broadly classified into the
following four stages viz.
(i)

Raw materials and stores stage;

(ii)

Work-in progress stage;

(iii)

Finished goods inventory stage; and

(iv)

Receivable collection stage;

The duration of the operating cycle for the purpose of estimating working capital requirements is equivalent
to the sums of the duration of each of these stages less the credit period allowed by the suppliers of the
firms.
Symbolically, the duration of the working capital cycle can be put as follows:
O=R+W+F +DC
Where,
O

Duration of opening cycle

Raw materials and stores storage period;

Work in process period;

Finished stock storage period;

Debtors collection period;

Creditors payment period.

Each of the component of the operating cycle can be calculated as follows:

Average stock of raw materials and stores

R = --------------------------------------------------------------------------------Average Raw Materials and stores consumption per day
Average work in process inventory
W = -------------------------------------------------------------------------------Average cost of production per day

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Average finished stock inventory

F = --------------------------------------------------------------------------------Average cost of goods sold per day
Average book debts
D = ---------------------------------------------------Average credit sales per day
Average trade creditors
C = ---------------------------------------------------Average credit purchases per day
After computing the period of one operating cycle, total number of operating cycles that can be completed
during a year can be computed by dividing 365 days with the number of operating days in a cycle. The total
operating expenditure in the year when divided by the number of operating cycles in a year will give the
average amount of the working capital requirements.

Approaches for Determining the Finance Mix

There are three approaches for determining the working capital financing mix.
(i)

The hedging approach According to this approach, the maturity of sources of funds should
match the nature of assets to be financed. The approach is therefore also termed as Matching
Approach. It divides the requirements of total working capital funds into two categories.
a. Permanent Working Capital, i.e. funds required for purchase of core current assets. Such
funds do not vary over time.
b. Temporary or Seasonal Working Capital, i.e. funds which fluctuate over time.

The permanent working capital requirements should be financed by long-term funds while the seasonal
working capital requirements should be financed out of short-term funds.

(ii)

The Conservative Approach According to this approach all requirements of funds should be
meet from long-term sources. The short-term sources should be used only for emergency
requirements.
The conservative approach is less risky, but mote costly as compared to the hedging approach.
In other words conservative approach is low profit low risk (or high cost, high net working
capital) while hedging approach results in high profit-high risk (for low cost, low net working
capital).

(iii)

Trade-off between hedging and conservative approached. The hedging and conservative
approach are both on two extremes. Neither of them can therefore help in efficient working
capital measurement. A trade-off between these two can give satisfactory results. The level of
such trade-off will differ from case to case depending upon perception of the risky by the
persons involved in financial decision- making. However, one way of determining the level of
trade-off is by finding the average working capital so obtained may be financed by long-term

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funds and the balance by short-term funds. For example, if during the quarter ending 31 st
March, the minimum working capital required is estimated at Rs. 10,000 while the maximum at
Rs. 15,000, the average level comes to Rs. 12,500 [i.e. (10,000 + 15,000) 2]. The firm should
therefore finance Rs. 12,000 from long-term sources while any extra capital required any time
during the period, from short-term sources while any extra capital required any time during the
period, from short-term sources (i.e., current liabilities)

BSPATIL

132