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Chapter 3: Sources of Finance for a Joint Stock Company

A company that decides to build a new plant faces a problem before it faces a market. The land, the machinery and the first few months of wages must all be paid for long before the plant earns anything. The promoters’ own savings rarely stretch that far, and this is precisely why the joint stock company exists: it can collect small amounts from a very large number of people and turn them into capital of a size no individual could raise. Money, however, is never given away. Whoever parts with it wants something in return — a share in the profits, a fixed dividend, interest, a date of repayment, security over the assets, or a say in how the company is run. Each source of finance is therefore a different bargain, and each bargain costs the company something: control, a fixed charge on its earnings, a claim on its property, or the freedom to decide its own dividend. This chapter examines the long-term and short-term sources of finance open to a joint stock company, the features of each, and the merits and demerits of raising money in each of these ways.

Figure

Fig. 3.0-1 — A New Manufacturing Unit Under Construction Photograph of a factory building under construction, with structural steel and cranes in place and the machinery yet to be installed.

3.1 Financial Needs Of A Joint Stock Company

Every business spends before it earns. A company must buy its machinery, fill its godown and pay its workers in the expectation of sales that have not yet taken place, and the money for all of this has to be arranged in advance. Finance is therefore the first requirement of a company, not the last.

Two questions follow from this. How much money will be needed, and where is it to come from. The first is a matter of financial planning; the second is the subject of this chapter, because the source a company chooses decides who acquires a claim on its profits, on its assets and on its management.

3.1.1 Why A Company Needs Funds

The purposes for which a company needs money differ in one important respect — the length of time for which the money remains locked up. That difference governs everything that follows.

  1. Purchase of fixed assets — land and buildings, plant and machinery, furniture and fixtures and motor vehicles are bought once and used for many years. Their cost is recovered only gradually, out of the earnings of several years, so it cannot be met from a source that demands early repayment.

  2. Permanent working capital — a minimum level of stock, debtors and cash must be maintained at all times if production and sale are not to stop. Since this minimum never falls to zero, the money tied up in it is needed as permanently as the money sunk in fixed assets.

  3. Day-to-day operations — wages, power, rent, raw material and other running expenses fall due every month, while payment from customers who have bought on credit arrives weeks later. Funds are needed to bridge the gap between spending and collection.

  4. Expansion and modernisation — additional plant, replacement of obsolete machinery and entry into a new line of production call for large sums at one time, which the company’s own earnings may not cover.

Figure

Fig. 3.1-1 — Stock Held In A Company’s Warehouse Photograph of cartons and sacks stacked in a company’s warehouse, showing funds locked up in goods awaiting sale.

3.1.2 Long-Term And Short-Term Finance

Because these needs differ in duration, the finance raised to meet them is classified in the same way.

Long-term finance is money that remains with the company for several years and is used to acquire fixed assets and to hold the permanent portion of working capital. It is raised by the issue of equity shares, preference shares and debentures, by ploughing back profits, and by taking long-period loans from commercial banks and financial institutions.

Short-term finance is money required for a year or less, ordinarily to carry stock and debtors until they turn back into cash. It is obtained through the various facilities offered by commercial banks, and through public deposits, trade credit, customer advances, factoring, inter-corporate deposits and instalment credit.

Where Companies Go For Money Companies in India raise long-term capital from the public by issuing shares and debentures. These securities are then listed and traded on the Bombay Stock Exchange and the National Stock Exchange, both situated in Mumbai. Every public issue is made under regulations framed by the Securities and Exchange Board of India.

The two must be matched to the need. A machine bought with money repayable in three months would have to be sold again to repay the lender, because in three months it cannot possibly have earned its own cost. Equally, a company that uses permanent capital to finance a temporary rise in stock is left paying for funds it no longer needs once the stock is sold. The full range of sources is set out in FC 3.1.

Flowchart

FC 3.1 — Sources Of Funds Of A Joint Stock Company Sources of funds → Long-term finance, Short-term finance; Long-term finance → Equity shares, Preference shares, Retained earnings, Debentures, Loans from commercial banks, Loans from financial institutions; Short-term finance → Assistance from commercial banks, Public deposits, Trade credit, Customer advances, Factoring, Inter-corporate deposits, Instalment credit

3.1.3 Owned Funds And Borrowed Funds

The same sources can be classified a second way, by asking who supplies the money and on what terms it is given.

Owned funds are contributed by the owners of the company or generated within it — equity share capital, preference share capital and retained earnings. They are not repayable during the lifetime of the company, and the return on them is payable only when profits are earned. In exchange for accepting that uncertainty, the suppliers of owned funds acquire ownership and, in the case of equity shareholders, control of the company.

Borrowed funds are supplied by creditors and lenders who never become owners — debentureholders, banks, financial institutions, depositors and suppliers. Because they take no share in the risk of the business, they are promised a fixed return on a fixed date, and that promise must be honoured whether or not the company has earned a profit. To make the promise safe, the lender usually asks for a charge on the company’s assets.

Each choice therefore costs the company something different, and the two are compared in Table 3.1.

Table 3.1 — Owned Funds And Borrowed Funds | Basis | Owned Funds | Borrowed Funds | |—|—|—| | Supplied by | Owners of the company | Creditors and lenders outside the company | | Main sources | Equity shares, preference shares, retained earnings | Debentures, bank and institutional loans, public deposits, trade credit | | Repayment | Not repayable during the lifetime of the company | Repayable on or before an agreed date | | Return payable | Dividend, only out of profits | Interest, whether or not there are profits | | Charge on assets | No charge is created | Usually secured by a charge on the assets | | Rights acquired | Ownership, with voting rights for equity shareholders | Creditorship only, with no voting rights | | Risk to the company | Low, since payment can be postponed in a bad year | High, since failure to pay invites legal action |

No company relies on one of these alone. Owned funds keep it safe but dilute the control of the original owners and give away a share of the profits; borrowed funds protect control and cost less, but fasten a fixed burden on earnings that a lean year will make heavy. The rest of this chapter takes each source in turn and examines what it offers the company and what it demands in return.

3.2 Equity Shares

A company needs permanent capital, and it needs it from people who will never take part in running the business. The issue of shares is the device that makes this possible, and it is the most important method by which a joint stock company raises long-term funds.

The whole of the capital required is divided into a large number of equal parts. A person of modest means can then take one part, and a wealthy investor many, so that a very large sum is assembled from a very large number of contributors without any of them being asked for more than he can afford.

3.2.1 Meaning Of A Share

The capital of a company divided in this manner is its share capital, and each of the equal units into which it is divided is a share. A share therefore measures the interest a member holds in the company — his portion of its capital, his claim on its profits and his share in whatever is left on a winding up.

Every share bears a face value, also called its nominal value, and a distinct number by which it is identified. The rights attaching to it, such as the right to a dividend and the right to vote, are those laid down in the articles of association of the company.

NoteDefinition

Share Under the Companies Act, 2013, a share is a share in the share capital of a company and includes stock. It is one of the equal units into which the capital of a company is divided, and it represents the interest of the shareholder in the company, measured by a sum of money.

In a well-known judicial description, Justice Farewell explained a share as the interest of a shareholder in the company measured by a sum of money, both for the purpose of his liability and for the purpose of his dividend, together with the other rights given to him by the articles of association.

A public company limited by shares may issue two kinds of shares — preference shares and equity shares. Preference shares are dealt with in the next section.

3.2.2 Features Of Equity Shares

Shares that carry no preferential right in the payment of dividend or in the repayment of capital are called equity shares, or ordinary shares. Every feature that follows is a consequence of that single fact: the equity shareholder stands last in the queue, and is compensated for it with ownership.

NoteDefinition

Equity Shares Equity shares are shares that carry no preferential right either in the payment of dividend or in the repayment of capital. Dividend on them is paid only after the preference dividend has been paid, and their capital is returned only after all other claims have been met.

  1. No preferential right — the equity shareholder is paid after the preference shareholder in respect of both dividend and capital. He is a residual claimant, and receives what is left after every fixed claim has been satisfied.

  2. Uncertain and fluctuating dividend — dividend is payable only when profits are earned and only when the company declares it. The Board of Directors recommends the rate, the shareholders approve it at the annual general meeting, and it rises and falls with the fortunes of the business.

  3. Repayment in the last — on a winding up, equity capital is returned only after creditors, debentureholders and preference shareholders have been paid, and only if a surplus remains. The equity shareholder therefore bears the maximum risk in the company.

  4. Voting rights and control — because he carries that risk, the equity shareholder is given the right to vote at general meetings, to elect the directors and thereby to control the management of the company.

  5. Permanent capital — equity capital is not repayable during the lifetime of the company. An investor who wants his money back does not ask the company for it; he sells his shares to another investor.

  6. Free transferability — the shares of a public company are freely transferable, and those listed on a stock exchange can be sold on any working day. It is this liquidity that persuades investors to part with money that the company will never return.

  7. Limited liability — the liability of an equity shareholder is limited to the amount remaining unpaid on the shares he holds. Beyond that sum his personal property cannot be touched to meet the debts of the company.

Figure

Fig. 3.2-1 — Shareholders At A Company’s Annual General Meeting Photograph of shareholders seated at a company’s annual general meeting, where the dividend recommended by the Board is placed before them for approval.

3.2.3 Advantages Of Equity Shares

To The Company

  1. No burden on earnings — dividend is payable only out of profits and only when the management proposes it. The company is under no obligation to pay a fixed rate, so a lean year does not force a payment it cannot afford.

  2. Permanent capital — since the money is returnable only on a winding up, the company can commit it to long-lived assets without having to keep a repayment date in view.

  3. No charge on assets — the issue of equity shares creates no mortgage or charge on the property of the company. The assets stay free, and can be offered as security later when the company wants to borrow.

  4. Strength in the market — a company with substantial equity capital is regarded as sound, because the owners’ money stands to absorb losses before any lender’s money is touched. Its creditworthiness, and therefore its ability to borrow, is high.

  5. Wide appeal — the face value of an equity share is kept low, so investors of small means can subscribe. A company is thereby able to mobilise the savings of a very large section of society.

Why The Face Value Is Kept Small Equity shares in India are commonly issued with a face value of ten rupees, and many companies use a face value of five, two or even one rupee. A small unit puts the share within reach of an ordinary saver, and allows a company to collect a very large sum from a very large number of investors.

To The Investor

  1. Control over the company — voting rights give equity shareholders the power to elect the Board and to decide the major questions placed before a general meeting.

  2. Limited liability — the investor knows in advance the maximum he can lose, which is the amount of his subscription.

  3. High return in prosperity — because all residual profit belongs to them, equity shareholders may receive a rate of dividend far above what any fixed-return security offers when the company does well.

  4. Capital appreciation — the market price of a share rises with the prosperity of the company, and a shareholder who sells at that price earns a capital gain in addition to his dividend.

  5. First claim on further issues — when the company issues fresh shares, they must ordinarily be offered to the existing equity shareholders before anyone else, so their proportionate holding need not be reduced.

3.2.4 Disadvantages Of Equity Shares

To The Company

  1. Dilution of control — every fresh issue of equity shares brings in new voters. A group that acquires a large block can direct the affairs of the company, and control may pass out of the hands of those who built it.

  2. Danger of over-capitalisation — equity capital cannot be returned during the lifetime of the company. If more is raised than the business can employ profitably, the same earnings are spread over a larger capital, the rate of return falls, and the financial structure cannot easily be corrected.

  3. Costly to raise — underwriting commission, brokerage and other issue expenses are higher on equity shares than on other securities. Dividend, moreover, is an appropriation of profit and is not deductible in computing the taxable income of the company, whereas interest on borrowings is.

  4. Loss of a cheaper alternative — a company financed wholly by equity gives away a share of every rupee of profit. Had part of the capital been raised at a fixed and lower rate of return, the surplus earned above that rate would have gone to the owners instead.

  5. Limited by authorised capital — a company cannot issue shares beyond the authorised capital stated in its memorandum of association, so this source is not available at will.

To The Investor

  1. Uncertain return — no dividend is received in a year of loss, and even in a profitable year the rate is what the Board recommends. Shareholders may reduce that rate but cannot increase it.

  2. Highest risk — the equity shareholder is paid last on a winding up and may receive nothing at all if the surplus is exhausted by prior claims.

  3. Fluctuating prices and speculation — share prices swing with the sentiment of the market and not always with the performance of the company. Speculative dealing, particularly during a boom, leaves the uninformed investor exposed.

  4. Little real voice for the small holder — voting power follows the size of the holding. A shareholder with a few shares is an owner in name, while effective control rests with those who hold large blocks.

3.3 Preference Shares

Between the investor who is willing to bear every risk of the business and the one who will lend only against a fixed date and a security, there stands a third kind of investor. He wants a steady and predictable income, is prepared to take it out of profits rather than demand it as a debt, and is not much interested in managing the company. Preference shares are addressed to him.

For the company the arrangement is attractive for a different reason. It raises ownership capital, which no creditor can claim back on a fixed date, and yet it parts with almost no control, because the price of the priority given to these shareholders is the surrender of their vote.

3.3.1 Meaning And Features Of Preference Shares

Preference shares are shares that carry two rights in preference to equity shares — a fixed dividend paid before the equity dividend, and the return of capital before equity capital on a winding up. Everything else about them follows from this exchange of control for priority.

NoteDefinition

Preference Shares Preference shares are shares carrying two preferential rights over equity shares: a dividend at a fixed rate, payable out of profits before any dividend is paid on equity shares, and the repayment of capital, on a winding up, before the capital of the equity shareholders is returned.

  1. Fixed rate of dividend — the rate is settled at the time of issue and does not change with the earnings of the company. The holder receives that rate and, unless his shares are participating, nothing beyond it however well the company does.

  2. Priority in dividend — no dividend may be paid on equity shares until the preference dividend for the year has been paid. The priority is over the equity shareholder only, and not over profits themselves: in a year without profits, no preference dividend is payable either.

  3. Priority in repayment of capital — on a winding up, preference capital is returned before equity capital, though after the claims of all creditors and debentureholders have been met. The preference shareholder therefore stands between the lender and the owner in the queue.

  4. No voting rights in the normal course — since these shareholders are largely insulated from the risk of the business, they take no part in its management. They may vote on resolutions that directly affect their own rights, and if their dividend has remained unpaid for two years or more they acquire the right to vote on all resolutions placed before the company.

  5. Limited life — in India preference shares cannot be issued for a term longer than twenty years, so a company cannot raise preference capital that it never has to return.

Hybrid Security A security that combines the features of two others. A preference share is a hybrid because, like an equity share, its dividend comes only out of profits, and like a debenture it carries a fixed rate and no vote.

3.3.2 Types Of Preference Shares

The basic bargain can be varied in four ways, and each variation exists because some investor wanted a particular assurance that the plain preference share does not give. The four pairs are set out in FC 3.2.

Flowchart

FC 3.2 — Types Of Preference Shares Preference shares → Cumulative or Non-cumulative; Participating or Non-participating; Convertible or Non-convertible; Redeemable or Irredeemable

  1. Cumulative preference shares — a dividend not paid in a year of inadequate profits is carried forward and added to the claim of later years. All such arrears must be cleared before any dividend is paid on any other class of shares, so a bad year postpones the holder’s income but does not destroy it. Unless the terms of issue state otherwise, preference shares are taken to be cumulative.

  2. Non-cumulative preference shares — a dividend not paid in a particular year is lost for ever. The claim does not accumulate, and the holder cannot demand it out of the profits of any later year.

  3. Participating preference shares — besides the fixed dividend, the holder is entitled to share in the surplus profits left after the equity shareholders have been paid a stated rate. He is thus given a stake in prosperity that an ordinary preference share does not offer.

  4. Non-participating preference shares — the holder receives the fixed dividend and nothing more, however large the surplus. Preference shares are non-participating unless the terms of issue provide otherwise.

  5. Convertible preference shares — the holder is given the option of converting his shares into equity shares after a stated period and on stated conditions. The option is an inducement, because it allows a cautious investor to begin with a safe fixed return and move to ownership once the company has proved itself.

  6. Non-convertible preference shares — these carry no such option and remain preference shares until they are redeemed.

  7. Redeemable preference shares — the capital is returned to the holder after the period fixed at the time of issue, or earlier at the option of the company. Only a company limited by shares may issue them, and the intention to redeem must be made clear when the shares are issued.

  8. Irredeemable preference shares — these are repayable only when the company is wound up. Because Indian law does not permit preference shares to be issued for a term beyond twenty years, irredeemable preference shares cannot now be issued by a company in India.

Q. A company earns no profit for two years and then earns a large profit in the third. What does a cumulative preference shareholder receive, and what does a non-cumulative preference shareholder receive?

A. The cumulative shareholder receives the arrears of all three years, and they must be paid before any dividend goes to the equity shareholders. The non-cumulative shareholder receives only the third year’s dividend; the first two years are lost to him for ever.

3.3.3 Advantages Of Preference Shares

To The Company

  1. Appeal to cautious investors — a fixed return backed by priority attracts savings from people who would not buy equity shares at all. The company reaches a class of investor that no other ownership security can bring in.

  2. No fixed burden on finances — dividend is payable only out of profits. In a year of loss the company pays nothing, and unlike an unpaid interest bill, an unpaid preference dividend gives the holder no right to sue.

  3. No dilution of control — as these shares carry no vote in the ordinary course, the promoters can raise substantial capital from outsiders without weakening their hold on the management.

  4. No charge on assets — the issue creates no mortgage on the property of the company, which therefore remains free to be offered as security when the company later wishes to borrow.

  5. Benefit of trading on equity — the preference dividend is fixed and usually modest. When the company earns more on the capital than it pays out on these shares, the surplus belongs to the equity shareholders and their rate of dividend rises.

Trading On Equity The practice of raising part of the capital at a fixed rate of return, so that any surplus earned above that rate goes to the equity shareholders and raises the dividend they receive.

  1. Flexibility — redeemable preference shares can be paid off once the company no longer needs the money, so it is not left carrying capital it cannot employ profitably.

  2. Strengthens the owned funds — preference capital forms part of the net worth of the company. It therefore improves creditworthiness and acts as a cushion for the debentureholders and other lenders who rank ahead of it.

To The Investor

  1. Regular and certain income — the rate being fixed, the holder knows what he will receive in any year in which the company earns a profit.

  2. Lower risk than equity — he is paid before the equity shareholder both in dividend and in the return of capital, so his money is exposed to less of the risk of the business.

  3. Protection of arrears — on cumulative shares, a dividend missed in a bad year is not lost but carried forward and paid later.

  4. Return of capital in due course — redeemable shares give the investor a date on which he can expect his money back, which an equity share never does.

3.3.4 Disadvantages Of Preference Shares

To The Company

  1. A costly source — the rate offered must be higher than the interest a debenture would carry, because the preference shareholder has no security and no assured payment. Dividend, moreover, is an appropriation of profit and is not deductible in computing taxable income, whereas debenture interest is.

  2. Burden in a bad year — the fixed dividend must be paid before anything reaches the equity shareholders. On cumulative shares a succession of poor years builds up arrears that fall on the first profitable year and leave the equity shareholder with nothing.

  3. Legal formalities on redemption — preference shares may be redeemed only if they are fully paid, and only out of profits available for dividend or out of the proceeds of a fresh issue of shares. The company cannot simply repay them out of whatever cash it holds.

  4. Limited funds can be raised — the security falls between two stools. The cautious investor prefers the safety of a debenture and the enterprising investor prefers the returns of an equity share, so the sums a company can collect through preference shares are modest.

To The Investor

  1. No voice in management — in the normal course these shares carry no vote, so the holder has no say in how the company is run even when his money is at stake.

  2. No share in prosperity — the dividend does not rise with the earnings of the company, and except on participating shares the holder is shut out of the surplus that his capital has helped to earn.

  3. No guarantee of dividend — if the company earns no profit, no dividend is payable, and the preference shareholder, unlike a debentureholder, has no legal remedy.

  4. Risk of being paid off — the company redeems these shares when it no longer needs the money, which is usually when funds are cheap and easy to get. The investor’s capital comes back at the moment least convenient to him.

  5. Less easily saleable — the market for preference shares is narrower than that for equity shares, so an investor wishing to sell may not find a buyer readily.

3.3.5 Equity Shares And Preference Shares Compared

Both are ownership securities and neither carries a promise that any dividend will ever be paid. The whole difference lies in what each class has given up in return for what it has been promised, and this is set out in Table 3.2.

Table 3.2 — Equity Shares And Preference Shares | Basis | Equity Shares | Preference Shares | |—|—|—| | Rate of dividend | Varies with the profits earned | Fixed at the time of issue | | Right to dividend | Paid after the preference dividend | Paid before the equity dividend | | Repayment of capital | Returned after all other claims | Returned before equity capital | | Voting rights | Full voting rights | No vote in the normal course | | Risk borne | Highest, as the residual claimant | Comparatively low | | Share in prosperity | Entire surplus profit belongs to them | Only the fixed dividend, unless participating | | Face value | Usually low | Usually higher | | Redemption | Not redeemable during the lifetime of the company | Redeemable within the period fixed | | Arrears of dividend | Never accumulate | Accumulate on cumulative shares | | Suits | Bold investors seeking returns and control | Cautious investors seeking safety and a steady income |

3.4 Other Methods Of Issuing Shares

A company does not always issue shares for cash to the general public. It may want to pass on accumulated profits without parting with cash, to raise fresh capital without disturbing the existing pattern of ownership, to hold on to the people who work for it, to pay for know-how it has no cash to buy, or to collect a large sum quickly from a few large investors.

Five methods answer these different needs. Each is a way of issuing shares, and each is examined here only for what it means and the purpose it serves.

3.4.1 Bonus Shares

A profitable company does not distribute the whole of its profit every year. Over time the undistributed portion builds up into large reserves, which belong to the shareholders but are lying in the business. If the company were to hand this money over as dividend, it would lose the working funds those reserves are financing.

Bonus shares are the way out. The company issues fully paid shares to its existing shareholders free of charge, in proportion to the shares they already hold, and the reserves are treated as having been converted into share capital. The shareholder’s holding grows, the cash stays in the business, and nothing leaves the company. For this reason the issue is also called a capitalisation of profits.

NoteDefinition

Bonus Shares Bonus shares are fully paid shares issued by a company to its existing shareholders free of charge, in proportion to their existing holdings, out of its accumulated undistributed profits. Because reserves are thereby converted into share capital, the issue is also known as a capitalisation of profits.

3.4.2 Rights Shares

When a company issues fresh shares to outsiders, the holding of every existing shareholder becomes a smaller fraction of a larger capital, and his share in the profits and in the control of the company shrinks accordingly. The law protects him against this.

A public company limited by shares that proposes to increase its subscribed capital by a further issue must first offer the new shares to its existing equity shareholders, in proportion to the shares they hold. Shares so offered are called rights shares, and the entitlement of the members to be offered them first is the right of pre-emption.

The offer is made by a notice, called a letter of offer, which states the number of shares offered and the period within which the offer must be accepted. If it is not accepted within that period it is treated as declined, and the directors are then free to dispose of the shares in the manner they consider most beneficial to the company. A shareholder who does not wish to subscribe may renounce his right in favour of another person, so the entitlement itself has a value even to a member who will not use it. The price is ordinarily set below the prevailing market price, which is what makes the offer worth taking up.

Rights shares and bonus shares are both offered to existing shareholders, and are for that reason easily confused. They are compared in Table 3.3.

Table 3.3 — Rights Shares And Bonus Shares | Basis | Rights Shares | Bonus Shares | |—|—|—| | Meaning | A further issue offered first to existing shareholders | Fully paid shares given free to existing shareholders | | Payment | Have to be paid for by the shareholder | Issued free of charge | | Effect on cash | Bring fresh funds into the company | Bring in no funds at all | | Purpose | To raise fresh capital without diluting existing holdings | To capitalise undistributed profits | | Paid-up value | May be partly paid | Always fully paid | | Effect on reserves | Reserves remain untouched | Reserves are converted into share capital | | Choice of the shareholder | May be taken up, renounced or declined | No choice arises, as nothing is asked of him |

3.4.3 Employee Stock Option Plan

A company that wants a valued employee to stay, and to work as though the business were his own, can offer him a part of that ownership. An employee stock option plan, commonly called an ESOP, is a scheme under which a company gives its employees or directors the right to buy a specified number of its shares at a stated price, usually below the prevailing market price, after they have fulfilled the conditions laid down in the scheme, such as a minimum period of service.

What the employee receives is an option and not an obligation. He may exercise it and become a shareholder, or let it lapse and take his remuneration in cash alone.

3.4.4 Sweat Equity Shares

A company may obtain from a director or an employee something it could not have bought for cash — a technical know-how, an intellectual property right made available to the company, or a substantial value addition to its business. Sweat equity shares are the means of paying for it in ownership rather than in money.

They are equity shares of a class already issued by the company, issued to directors or employees either at a discount or for a consideration other than cash. Since they are issued for what a person has contributed by his own effort and skill, they cannot be sold immediately, and they serve to bind the recipient to the company for the years in which his contribution matters most.

NoteDefinition

Sweat Equity Shares Sweat equity shares are equity shares issued by a company to its directors or employees at a discount, or for a consideration other than cash, for providing know-how, for making available intellectual property rights, or for value additions made by them to the company.

3.4.5 Qualified Institutional Placement

A public issue of shares takes months of preparation and is expensive to make. A listed company that needs a large sum at short notice can instead go to a small number of large and well-informed investors.

A qualified institutional placement, commonly called a QIP, is an issue of shares or other specified securities by a listed company to qualified institutional buyers — mutual funds, insurance companies, banks, pension funds and similar investors. Because these buyers are professional investors capable of judging the offer for themselves, the issue is completed with far fewer formalities than a public issue, and the company obtains its funds quickly.

NoteDefinition

Qualified Institutional Placement A qualified institutional placement is an issue of shares or other specified securities by a listed company to qualified institutional buyers, such as mutual funds, insurance companies and banks, made in accordance with the regulations framed by the Securities and Exchange Board of India.

3.5 Retained Earnings

Every source considered so far requires the company to go outside and persuade somebody — an investor to buy its shares, a lender to part with money against a promise of repayment. There is one source it need ask nobody for, and that is its own profit.

A company that does not distribute the whole of what it earns keeps the balance in the business. Over the years this becomes a fund of considerable size, and it is capital the company has raised from itself.

3.5.1 Meaning Of Retained Earnings

The profit left after tax belongs to the equity shareholders. The Board of Directors recommends only a part of it for distribution as dividend, and the remainder is kept back and put to work in the business. That retained portion is what is meant by retained earnings.

The same process is described in two other ways. It is called ploughing back of profits, because the earnings of the business are returned to the soil that produced them, and self-financing, because the company meets its needs from within instead of approaching the market. It is an internal, long-term source, and it forms part of the owned funds of the company.

NoteDefinition

Retained Earnings Retained earnings are that part of the net profit of a company which is not distributed as dividend but is kept back and reinvested in the business. Since the company finances itself out of its own earnings, the source is also called ploughing back of profits or self-financing.

Where The Reserves Are Shown Accumulated retained earnings do not appear in a company’s accounts as a source of finance. They are shown in the balance sheet as reserves and surplus, under shareholders’ funds. Two companies with the same share capital may therefore command very different sums, depending on how much each has ploughed back over the years.

3.5.2 Factors Determining Retained Earnings

How much a company is able to retain is not a matter of choice alone. Four circumstances govern it.

  1. The amount of net profit — nothing can be ploughed back that has not first been earned. A company with large and steady profits has a wide margin to retain, while one with slender earnings has almost none.

  2. The dividend policy of the company — a company that has undertaken to pay a liberal and regular dividend every year is left with little to retain, because the claim of the shareholder is settled first. A company following a conservative dividend policy retains a much larger share of its profit.

  3. The age of the company — a new company must satisfy its shareholders and establish its standing in the market, and therefore distributes generously. An old company with a settled body of shareholders and an established reputation can retain the greater part of its profit without complaint.

  4. Future plans — a company that intends to expand, modernise or diversify begins to hold back profits in the years before the outlay, so that the money is in hand when the work begins.

3.5.3 Merits Of Retained Earnings

  1. The most convenient source — the money is already with the company. There is no prospectus to issue, no underwriting commission or brokerage to pay, no lender to negotiate with and no formality to complete, which makes this the cheapest of all sources.

  2. No fixed obligation — retained earnings carry no interest, no repayment date and no promise of any return. Nothing has to be paid out in a bad year, so the source adds nothing to the fixed burden on earnings.

  3. The financial structure stays flexible — no charge is created on the assets and no condition is imposed by any lender. The assets remain free to be offered as security, so the company’s ability to raise further finance is untouched.

  4. Greater financial strength — a company with large reserves can meet an unexpected loss, a strike or a downturn in trade out of its own resources. Its creditworthiness rises accordingly, and lenders advance money to it more readily and on better terms.

  5. Independence of the capital market — expansion and modernisation can be undertaken when the company judges the time right, and need not be postponed because share prices are low or investors unwilling.

  6. A stable rate of dividend — reserves built up in profitable years can be drawn upon to maintain the dividend in a lean one. Shareholders receive a steady return, and relations with them remain good.

  7. No dilution of control — since no fresh shares are issued, no new voters enter the company and the existing shareholders retain their hold on the management.

Q. Retained earnings carry neither interest nor dividend. Does it follow that they cost the company nothing?

A. No. The money belongs to the equity shareholders, who have gone without a dividend so that it may stay in the business. They expect the company to earn on it at least as much as they could have earned by investing it elsewhere, so the source has a cost even though no payment is made.

3.5.4 Demerits Of Retained Earnings

  1. Dissatisfaction among shareholders — heavy retention year after year means a low dividend. Shareholders who bought the shares for an income feel their money is being used without reward, and some of them sell, which depresses the price of the share.

  2. Careless investment — because the funds have cost nothing visible, they may be committed to unprofitable lines or spent wastefully. No lender examines the proposal and no investor has to be convinced of it, so the discipline that outside finance imposes is absent.

  3. Danger of over-capitalisation — reserves that keep growing are often capitalised by repeated bonus issues. If the earnings of the company do not grow at the same pace, they are spread over a larger capital, and the rate of return falls.

  4. Scope for manipulation — the existence of large undisclosed reserves is known to those inside the company before it is known to the market. Such knowledge can be used to speculate in the company’s shares at the cost of the ordinary investor.

  5. An unreliable source — profits vary from year to year, and a company cannot know in advance how much it will be able to retain. Large commitments cannot safely be planned on the strength of a source that may dry up.

  6. Unbalanced industrial growth — profits earned in one industry are ploughed back into the same industry instead of passing through the capital market to those industries that need capital most. Growth becomes lopsided, and the natural development of the capital market is hindered.

  7. Concentration of economic power — a company that finances itself out of its own profits year after year can grow very large without ever submitting itself to the judgement of investors, and economic power comes to rest in a few hands.

3.6 Debentures

A company that has sold ownership to everyone willing to buy it may still need money, and may be unwilling to give away any more of its control. There is also a large class of investor who will not take the risk of ownership on any terms. He wants a return that does not depend on the company’s profits, a date on which his money will come back, and something to fall back on if it does not.

Debentures are the instrument that brings the two together. The company borrows instead of selling a further share in itself, and the investor lends instead of becoming an owner.

3.6.1 Meaning And Characteristics Of Debentures

Debentures denote borrowing by a company and represent its loan capital. A debenture is a certificate issued by the company acknowledging that a sum of money has been lent to it, and undertaking to repay that sum with interest on or before a prescribed date. The holder is therefore a creditor of the company and not a member of it.

NoteDefinition

Debenture According to Evelyn Thomas, a debenture is a document under the company’s seal which provides for the payment of a principal sum and interest on it at regular intervals, is usually secured by a fixed or floating charge on the company’s property or undertaking, and acknowledges a loan to the company.

  1. Borrowed funds — the money raised belongs to the lender and not to the company’s owners. It forms part of the company’s borrowings and must one day be returned.

  2. Fixed rate of interest — the rate is settled at the time of issue and does not vary with the earnings of the company, because the lender has agreed to take no part in its fortunes.

  3. Interest payable irrespective of profits — interest is a charge against profits and not an appropriation of them. It falls due in a year of loss exactly as in a year of profit, and it is deductible in computing the taxable income of the company.

  4. No voting rights — as a creditor, the debentureholder takes no part in management. Borrowing therefore leaves the control of the company exactly where it was.

  5. Usually secured — debentures are ordinarily issued against a charge on the assets of the company, which is what allows the company to borrow at a lower rate than it could otherwise obtain.

  6. Repayable on a fixed date — the money is returned after the period stated in the terms of issue, or at the time of winding up.

  7. A legal remedy on default — if interest or principal is not paid when due, debentureholders may enforce their security and take legal action against the company, including a petition for its winding up.

Fixed And Floating Charges

Where the debentures are secured, the charge created is of one of two kinds. A fixed charge is created on specific and existing assets, such as land or a particular machine, and the company cannot dispose of those assets without the consent of the debentureholders. A floating charge covers assets of a changing kind, both present and future, such as stock and book debts, and leaves the company free to deal with them in the ordinary course of business. Every charge a company creates must be registered.

Floating Charge A charge on the changing assets of a company, such as stock and debtors, which leaves the company free to deal with them in the ordinary course of business and fastens on them only on default or liquidation.

3.6.2 Kinds Of Debentures

Debentures are classified in four ways, according to the security behind them, the date of their repayment, the manner of their transfer and the option they carry. The four pairs are set out in FC 3.3.

Flowchart

FC 3.3 — Kinds Of Debentures Debentures → Naked or Mortgage; Redeemable or Irredeemable; Bearer or Registered; Convertible or Non-convertible

  1. Naked debentures — also called simple debentures, these carry no charge on any property of the company and rest on its promise to pay. On default the holder may sue the company, but he has no particular asset out of which he can be paid, so only a company of undoubted standing can raise money on them.

  2. Mortgage debentures — also called secured debentures, these are issued by creating a fixed or floating charge on the assets of the company. If the company defaults, the holders can realise their dues out of the property charged.

  3. Redeemable debentures — these are repayable on a date fixed at the time of issue, or at any earlier time at the option of the company. Most debentures issued today are of this kind.

  4. Irredeemable debentures — also called perpetual debentures, these are repayable only when the company is wound up, so the holder receives interest indefinitely but cannot call for his principal.

  5. Bearer debentures — these are transferable by mere delivery, no record of the holder being kept by the company. Interest is paid on production of the coupons attached to the debenture, and neither a transfer deed nor notice to the company is required.

  6. Registered debentures — the names of the holders are entered in the register of debentureholders. Interest is paid only to the registered holder, and a transfer is effective only when a transfer deed is executed and intimated to the company.

  7. Convertible debentures — the holder is given the option of converting his debentures into equity shares after a stated period and on stated conditions. The option is an inducement, because it lets a cautious lender become an owner once the company has proved itself.

  8. Non-convertible debentures — these carry no right of conversion and remain a loan until they are redeemed.

3.6.3 Advantages Of Debentures

To The Company

  1. Control is not disturbed — debentures carry no voting rights, so a company can raise large sums without admitting anyone to the management or weakening the position of the existing shareholders.

  2. Benefit of trading on equity — the rate of interest is fixed. Everything the company earns on the borrowed money above that rate belongs to the equity shareholders and raises the rate of dividend they receive.

  3. An economical source — investors regard a secured debenture as safe and are therefore content with a lower return than they would demand on shares. Underwriting commission, brokerage and other issue expenses are also lower.

  4. Relief in taxation — interest is deductible while computing the taxable income of the company, which reduces the effective cost of the borrowing. Dividend, being an appropriation of profit, gets no such relief.

  5. Flexibility — redeemable debentures can be paid off when the company no longer needs the money, so it is not left carrying idle capital and its financial structure remains adjustable.

Debentures Offered To The Public Companies and non-banking finance companies in India regularly raise long-term money by public issues of non-convertible debentures. Each issue states the rate of interest and the date of redemption in advance, and the debentures are listed on the stock exchanges, so a holder who wants his money before the redemption date can sell them to another investor.

To The Debentureholder

  1. A regular and certain income — interest is paid at a fixed rate and at fixed intervals whether the company earns a profit or not, so the holder is free of the risk of fluctuating earnings.

  2. Safety of investment — the money is usually secured by a charge on the assets, and on a winding up the debentureholder is paid before every shareholder.

  3. A remedy in law — unlike a shareholder, a debentureholder whose dues are not paid can enforce his security and proceed against the company.

3.6.4 Disadvantages Of Debentures

To The Company

  1. A permanent burden of interest — interest must be paid whether or not there are profits. During a depression it becomes a heavy drain on a shrinking income and may threaten the solvency of the company.

  2. Charge on assets — the assets mortgaged are no longer free. The company cannot deal with them as it wishes, and its ability to raise further loans against them is exhausted.

  3. Reduction in credit standing — a company that has issued a large number of debentures is regarded as a risky borrower. Banks and financial institutions lend to it less readily and on harder terms.

  4. Less left for the shareholders — in a lean year interest absorbs the greater part of the profit, little or nothing remains for dividend, and the market value of the company’s shares falls.

  5. Not open to every company — only a company with sufficient fixed assets to offer as security and a record of stable earnings can raise money in this way. A new company or one with fluctuating income cannot.

To The Debentureholder

  1. No voting rights — the holder has no voice in the management of a company to which he has lent a large sum, and must rely on the shareholders to run it prudently.

  2. No share in prosperity — however well the company does, the interest remains what it was. The holder gets none of the gain that the equity shareholder enjoys.

  3. High unit price — debentures are ordinarily issued in larger denominations than shares, so investors of small means cannot buy them.

  4. Little appeal to the enterprising investor — an investor who wants a high return and an appreciation in the value of his holding will not buy debentures, and those of a new or little-known company find few takers of any kind.

3.6.5 Shares And Debentures Compared

A shareholder buys a part of the company; a debentureholder lends money to it. Every difference between the two securities follows from that one distinction, and they are set out in Table 3.4.

Table 3.4 — Shares And Debentures | Basis | Shares | Debentures | |—|—|—| | Status of the holder | Owner and member of the company | Creditor of the company | | Return | Dividend, payable only out of profits | Interest, payable whether or not there are profits | | Nature of the return | Fluctuates with profits on equity shares | Fixed and regular | | Voting rights | Carried by equity shares | None | | Security | Issued without any charge on assets | Usually secured by a fixed or floating charge | | Repayment | Returned on a winding up, except redeemable preference shares | Repayable on the date fixed | | Order of repayment | After all creditors have been paid | Before any class of shareholder | | Treatment for tax | Dividend is not deductible from taxable income | Interest is deductible from taxable income | | Convertibility | Cannot be converted into debentures | May be convertible into shares | | Collection of money | Ordinarily collected in instalments | Ordinarily collected in a lump sum |

Case 3.1 — Money For A New Furnace Kesar Alloys Limited needs a large sum to install a new furnace. Its promoters hold a bare majority of the equity capital and are unwilling to see their holding reduced. The company owns a factory building free of any charge, and its earnings over the last eight years have been steady. Q. Name the source of long-term finance best suited to Kesar Alloys Limited and give two reasons for the choice, drawn from the facts stated.

3.7 Loans From Commercial Banks And Financial Institutions

A public issue of shares or debentures is expensive, takes months to complete and is realistically open only to a company that already has a name in the market. A company that needs a definite sum for a definite purpose, and needs it soon, can do something simpler: borrow the whole amount from a single lender who will examine the proposal himself and hand the money over.

Two kinds of lender do this. Commercial banks lend chiefly against security and for shorter periods, and the specialised financial institutions, set up for the purpose, lend for longer periods and to companies the market would not touch.

3.7.1 Term Loans From Commercial Banks

Most of the money a bank lends is money its depositors can demand back at short notice, and this is why banks provide mainly short-term finance. Within limits, however, they also lend for medium and long periods, particularly to small-scale and medium-sized enterprises that have no access to the capital market at all.

Such long-period lending takes the form of a term loan. The bank sanctions a fixed sum, pays it over in a lump sum, and charges interest at an agreed rate on the amount sanctioned. Repayment is made in instalments spread over the period of the loan, so that the asset bought with the money can pay for itself out of what it earns. The loan is advanced against the security of some asset of the company, or on the personal guarantee of the borrower.

Term Loan A loan under which a bank advances a fixed sum in a lump sum for a specified period, at an agreed rate of interest, repayable in instalments and secured by the borrower’s assets or a personal guarantee.

Figure

Fig. 3.7-1 — A Loan Proposal At A Bank Branch Photograph of a customer discussing a loan proposal with an officer at the counter of a commercial bank branch.

3.7.2 Merits And Demerits Of Bank Loans

Merits

  1. Funds for a known period — the company knows exactly how much it has, for how long, and what it must repay each year, so the borrowing can be planned against the earnings the asset will produce.

  2. Control is not disturbed — a bank is a lender and not an owner. It acquires no vote, no share in the profits and no place in the management.

  3. Benefit of trading on equity — the rate of interest is fixed and is usually below what the company earns on the money. Everything above that rate belongs to the equity shareholders.

  4. Relief in taxation — interest on a bank loan is deductible in computing the taxable income of the company, which lowers the real cost of the borrowing.

  5. Speed and secrecy — there is no prospectus and no public disclosure. Terms are settled privately with the bank, so the money is obtained far more quickly and far more cheaply than by an issue to the public, and a continuing relationship with a well-known bank adds to the company’s standing.

Demerits

  1. Security has to be furnished — assets must ordinarily be pledged or mortgaged, and once charged they cannot be offered again to raise further finance.

  2. Formalities and delay — the bank investigates the proposal, calls for accounts, projections and documents, and satisfies itself before sanctioning. The process is slow, and a company in urgent need may not be able to wait.

  3. A fixed burden on profits — interest and instalments fall due whether or not the year has been profitable, and continued default entitles the bank to realise the security.

  4. Reduced capacity to borrow further — a company already carrying a large loan, with its assets charged, is a less attractive borrower, and additional finance becomes harder and dearer to obtain.

Collateral Security Property such as title deeds, shares, life insurance policies or fixed deposit receipts, left with a lender by a borrower, which the lender may dispose of to recover his money if the borrower defaults.

3.7.3 Loans From Financial Institutions

A new company, or one modernising on a large scale, needs money for longer than a bank ordinarily lends it and in amounts larger than a bank will ordinarily risk, and it frequently has no record of past earnings to show. Left to the market, such a venture would never be financed at all.

To fill that gap the Government of India established a number of special institutions, commonly called development banks. They include the Industrial Finance Corporation of India, the Industrial Development Bank of India, the Industrial Credit and Investment Corporation of India and the Small Industries Development Bank of India, and, at the level of the States, the State Financial Corporations. The Life Insurance Corporation of India and the General Insurance Corporation of India also provide long-term funds to industry.

These bodies are not simply lenders of money. They provide finance both as equity and as debt, subscribing to shares and debentures and underwriting public issues; they grant loans and guarantees in foreign currency for the import of machinery; and they offer promotional, technical and managerial services besides. Their purpose is to locate the gaps in the country’s industrial structure and to see that they are filled.

Institutions Built For Industry The Industrial Finance Corporation of India was the first of the special institutions established in the country to provide long-term finance to industry. The Small Industries Development Bank of India is the apex institution for the financing and development of small and medium enterprises, and the State Financial Corporations perform a similar service for smaller units within each State.

3.7.4 Merits And Demerits Of Institutional Finance

Merits

  1. Both kinds of capital are available — these institutions supply loan capital and risk capital alike, and will underwrite an issue as well. A company can therefore meet its entire requirement from a single source.

  2. Open to new concerns — a company that would find it impossible to raise money from the public can obtain it here, because these institutions were created precisely to finance ventures the market will not.

  3. Long periods and convenient repayment — funds are lent for long terms and repayment is arranged in easy instalments suited to the earnings of the project.

  4. Expert advice — the institution studies the project thoroughly before assisting it, and the advice and guidance it gives on planning and administration are often worth as much to a young company as the money.

  5. Improved standing — because assistance is granted only after a searching examination, a company that receives it is regarded as sound, and other finance becomes easier to obtain.

  6. Foreign currency assistance — loans, guarantees and deferred payment facilities in foreign currency allow a company to import the machinery and equipment it needs.

Demerits

  1. A searching investigation — the company must open its affairs to detailed scrutiny and complete a great many formalities, and the assistance takes long to come through.

  2. Deserving concerns may be refused — many companies fail to obtain help for want of security or because they cannot satisfy the other conditions laid down.

  3. Restrictions on the autonomy of management — these institutions may insist on a clause allowing them to convert their loan into equity shares, and on nominating their own directors to the Board. Management is then no longer free to decide every question for itself.

  4. A fixed obligation — interest and instalments must be paid on the due dates irrespective of the profits earned, and the assets financed stand charged until the loan is repaid.

The choice between the two lenders turns on what the company needs besides money, and this is set out in Table 3.5.

Table 3.5 — Loans From Commercial Banks And Loans From Financial Institutions | Basis | Loans From Commercial Banks | Loans From Financial Institutions | |—|—|—| | Period of lending | Chiefly short and medium term | Medium and long term | | Form of assistance | Loan alone | Loan, equity and underwriting of issues | | Suitable for | Established concerns with security to offer | New and expanding concerns, including those the market will not finance | | Formalities | Comparatively fewer | A detailed investigation of the whole project | | Services besides finance | None beyond ordinary banking facilities | Technical, managerial and promotional guidance, and foreign currency assistance | | Effect on management | No interference in management | May nominate directors and convert the loan into equity |

3.8 Short-Term Sources Of Finance

A company’s short-term problem is different in kind from its long-term one. Raw material and wages have to be paid for weeks or months before the customer who bought on credit pays for the finished goods. The gap is temporary, it recurs with every cycle of production, and if it is not bridged the factory stops even though the business is thoroughly profitable.

It would be wasteful to raise permanent capital for a need that disappears the moment the debtors pay. What the company wants is money it can take when the gap opens and return when it closes, and the sources described here are all of that kind.

3.8.1 Short-Term Assistance From Commercial Banks

Commercial banks are the largest single source of short-term finance for business, and they provide it in four different forms, set out in FC 3.4.

Flowchart

FC 3.4 — Forms Of Short-Term Bank Finance Short-term bank finance → Loans and advances, Cash credit, Bank overdraft, Discounting of bills; Cash credit → Clean cash credit, Secured cash credit

  1. Loans and advances — the bank sanctions a fixed sum, credits it to a separate loan account in the borrower’s name and pays over the whole of it at once. Interest runs on the entire sanctioned amount from the date of sanction, whether or not the borrower has used it, and repayment is made in one or more instalments. A loan granted for an immediate need, such as holding stock, is usually secured by a pledge of specific goods.

  2. Cash credit — this is a formal revolving credit agreement under which the borrower may draw up to a fixed limit. Unlike a loan it is a running account: money can be withdrawn and paid back from time to time within the limit, and interest is charged only on the amount actually used. The borrower is thus spared the need to negotiate afresh each time and the cost of interest on idle money. Where the arrangement is backed by no security it is called clean cash credit, the borrower giving a promissory note signed by two or more sureties; where tangible assets or guarantees are furnished it is a secured cash credit. The limit is fixed according to the financial position of the borrower, and the facility is available only to firms of high credit standing.

  3. Bank overdraft — a temporary accommodation allowed to a regular customer who holds a current account with the bank, permitting him to overdraw that account up to a specified amount for a few days. Interest is charged on the amount actually overdrawn and not on the amount sanctioned, which makes it a cheap way of meeting a shortage that will last a week.

  4. Discounting of bills — a company that has sold goods on credit holds a bill of exchange payable at a future date. The bank pays it a sum lower than the face value at once and collects the full amount on maturity, the difference being its charge. The company thus turns a claim due in three months into cash today, but it remains liable to the bank if the bill is dishonoured on maturity.

Cash Credit A revolving arrangement under which a bank allows a borrower to draw up to a fixed limit as and when required, interest being charged only on the amount actually utilised.

Cash credit and overdraft are the two facilities most often confused, and they are compared in Table 3.6.

Table 3.6 — Cash Credit And Bank Overdraft | Basis | Cash Credit | Bank Overdraft | |—|—|—| | Nature | A formal revolving credit agreement | A temporary accommodation | | Account operated | A separate cash credit account | The borrower’s own current account | | Period | For a longer period, and renewable | For a few days only | | Amount | A larger limit, fixed by the borrower’s financial position | A smaller sum, specified for the occasion | | Purpose | To finance the regular working capital requirement | To meet a sudden and temporary shortage | | Repeated use | Drawings may be made and repaid within the limit | The bank’s approval is needed on each occasion |

Merits And Demerits Of Bank Credit

Bank credit is flexible, since it can be repaid whenever the company chooses; it comes in several forms, so the company can pick the one suited to its need; the bank maintains secrecy about the borrower’s affairs; it takes no part in the management of the business; and in deserving cases repayment can be rescheduled.

Against this, the borrower must complete a number of legal formalities, and the bank will usually require security, so a charge is created on the company’s assets. Bank finance is granted for short periods with no certainty of renewal, and the rate of interest is high, so the arrangement fastens a fixed burden on profits.

3.8.2 Public Deposits

Public deposits are deposits of money accepted by non-banking companies directly from the public, including their own shareholders and employees. They are in substance loans from the public, and they became popular in India at a time when banking facilities were not well developed. The depositor receives a higher rate of interest than a bank deposit would pay him, while the company finds the money cheaper than borrowing from a bank or an institution.

For the company the arrangement is economical and simple. The administrative cost is far below that of issuing shares or debentures, few formalities are involved, and the interest paid is deductible in computing taxable income. Since the rate is fixed, the company enjoys the benefit of trading on equity. No charge is created on the assets, so they remain free for later borrowing; depositors have no vote, so control is not diluted; and the money can be repaid when it is no longer required, which keeps the financial structure flexible.

The weaknesses of the source lie in the same feature that makes it convenient. Deposits are unsecured and repayable at short notice, and depositors withdraw them precisely when the economy looks uncertain and the company most needs them, which is why they are described as ‘fair weather friends’. For the same reason the source is not available to a new company or to one with uncertain earnings, since nobody will hand money to a firm he cannot judge. Widespread reliance on public deposits also distorts the pattern of interest rates and starves the market of sound industrial securities. And a company that uses this money to buy fixed assets will be unable to return it on demand.

3.8.3 Trade Credit

Trade credit is credit extended by one business firm to another, incidental to the sale or purchase of goods and services. It is also called mercantile credit. The buying firm receives its supplies without paying for them at once, ordinarily for a period ranging from fifteen days to three months.

The credit does not place any cash in the buyer’s hands; it saves him from parting with the cash he has. Goods that would have absorbed his money are held and often sold before the supplier’s bill falls due, so the supplier has in effect financed his stock. It is extended in two forms. Under an open account no formal debt instrument is signed, the buyer’s obligation appearing only in the books of the two firms. Where bills are used, the buyer gives a written promise to pay the amount of the invoice on a fixed date in the future.

Stock Financed By The Supplier A retailer who receives goods from a wholesaler on thirty days’ credit will usually have sold a good part of them before the invoice falls due. He pays the wholesaler out of the sale proceeds. The stock on his shelves has therefore been financed by the supplier, and no bank and no capital of his own has been used.

Trade credit is simple, convenient and available in the ordinary course of business, no security being required and no formalities gone through. It grows automatically as the volume of purchases grows, and no charge is created on the assets of the buyer.

Its cost, however, is real even though no interest appears on the invoice. Prices charged on credit sales are higher than on cash sales, and the buyer forfeits the cash discount he would have earned by paying at once. The amount and the terms available depend on his financial standing and goodwill, on the custom of the trade and on the resources of the supplier, so a firm of doubtful reputation gets little of it.

Figure

Fig. 3.8-1 — Goods Delivered To A Retailer On Credit Photograph of cartons being unloaded at a retail shop, where the supplier’s invoice will fall due some weeks after the goods have arrived.

3.8.4 Customer Advances

Where goods are in short supply, or where delivery involves a waiting period, the manufacturer is in a position to ask the customer to pay before the goods are made. Customer advances are the sums so collected at the time of booking, representing a part of the price of goods to be supplied later. Nominal interest may be allowed on them, and at the time of delivery the advance is adjusted against the price of the article.

The money costs the company almost nothing, requires no security and involves no formalities, and it stays with the company until delivery. It is also a token of the customer’s commitment, so production can be planned against firm orders.

The source is narrow, however. Only a firm making durable products that are in short supply or take time to deliver can ask for an advance at all; the amounts are limited to a part of the price; and where competition allows the customer to buy the same thing elsewhere at once, he will not pay in advance for it.

3.8.5 Factoring

A company that has sold on credit owns a valuable asset in its book debts, but that asset yields nothing until the debtors pay. Factoring is the means of turning it into cash at once.

Finance companies known as factors provide funds either by buying the accounts receivable outright or by lending against their security, advancing generally up to about sixty per cent of the receivables pledged. Where the sale is outright, the business concern is relieved of the whole cost and effort of collecting its debts and of the losses from bad debts, which pass to the factor. Where the receivables are merely pledged, the debtors pay the firm, which passes the money on to the finance company, and any bad debt losses remain with the firm itself.

The method is an expensive one, because receivables have to be sold at a heavy discount, and a company uses it when it values immediate cash more than the full value of its debts.

Factoring The outright sale of a firm’s book debts to a finance company, called a factor, which pays the firm at once at a discount and takes over the work of collecting from the debtors.

3.8.6 Inter-Corporate Deposits

When a company borrows for a short period, say up to six months, from another company that happens to be holding surplus funds, the arrangement is called an inter-corporate deposit.

Such deposits are generally unsecured and are arranged through a financier. They are convenient and popular because hardly any legal formality is involved and the identity of the borrower is not disclosed to the public. The rate of interest varies with the amount and the period, and is usually lower than what a bank would charge. Since the whole arrangement rests on personal connections between the lenders, the borrowers and the brokers who bring them together, these deposits are available only to companies of good reputation.

3.8.7 Instalment Credit

Instalment credit is the facility of buying machinery, equipment and other durable goods on credit. The buyer pays a part of the price at the time of delivery and the balance in several instalments. The supplier charges interest on the amount outstanding and includes it in the instalment itself, and some suppliers arrange the facility through finance companies and commercial banks.

A firm may also acquire fixed assets on a hire purchase basis. Under that arrangement ownership of the asset remains with the supplier until the last instalment has been paid, though the buyer has the use of it from the first day.

Either way, the value of this source is that the asset can be put to work at once and paid for out of what it earns, so a firm that could not have found the whole price is not kept waiting. The rate of interest charged, however, is high, and the total sum paid is well above the cash price of the asset.

Case 3.2 — The Season Before The Sale Nandini Fabrics buys yarn in bulk in July and begins selling finished cloth only in October. Wages and yarn have to be paid for now, while its customers, who buy on credit, pay sixty days after delivery. The company has no spare asset to offer as security, and does not wish to raise permanent capital for a need that lasts a few months. Q. Name two short-term sources of finance suitable for Nandini Fabrics and state, for each, one reason why it fits the situation described.

3.9 Summary

  1. A company must pay for its assets and its operations long before it earns anything, so finance is its first requirement. Funds are needed to buy fixed assets, to hold the permanent portion of working capital, to meet day-to-day expenses until customers pay, and to expand and modernise.
  2. Sources of finance are classified in two ways:
  1. By duration — long-term finance remains with the company for several years and pays for fixed assets and permanent working capital; short-term finance is needed for a year or less to carry stock and debtors until they turn back into cash.
  2. By ownership — owned funds are supplied by the owners and are not repayable during the lifetime of the company, their return depending on profits; borrowed funds come from creditors, carry a fixed return on a fixed date and are usually secured by a charge on the assets.
  1. A share is one of the equal units into which the capital of a company is divided, and it measures the interest of the shareholder in the company. A public company limited by shares may issue equity shares and preference shares.
  2. Equity shares carry no preferential right in the payment of dividend or in the repayment of capital. The equity shareholder is a residual claimant who bears the maximum risk, and is compensated for it with voting rights and control of the company.
  3. Equity shares give the company permanent capital, lay no fixed burden on its earnings and create no charge on its assets, but they dilute control, cost more to issue than other securities and cannot be returned during the lifetime of the company.
  4. Preference shares carry a fixed dividend payable before the equity dividend and a return of capital before equity capital, and in exchange carry no vote in the normal course. They may be:
  1. cumulative or non-cumulative, according to whether unpaid dividends are carried forward
  2. participating or non-participating, according to whether the holder shares in surplus profits
  3. convertible or non-convertible, according to whether they may be turned into equity shares
  4. redeemable or irredeemable, though irredeemable preference shares can no longer be issued in India
  1. Preference shares let a company raise ownership capital without diluting control and without a fixed obligation to pay, but they cost more than debentures, the dividend earns no relief in tax, and only limited sums can be raised because the security appeals to a narrow class of investor.
  2. Shares are also issued in ways that do not involve a public issue for cash:
  1. Bonus shares — fully paid shares given free to existing shareholders out of accumulated profits, by which reserves are capitalised.
  2. Rights shares — a further issue offered first to the existing equity shareholders, who hold the right of pre-emption.
  3. Employee stock option plan — the right given to employees or directors to buy a stated number of shares at a stated price on fulfilling the conditions of the scheme.
  4. Sweat equity shares — equity shares issued to directors or employees at a discount or for a consideration other than cash, for know-how, intellectual property rights or value additions.
  5. Qualified institutional placement — an issue of shares or other specified securities by a listed company to qualified institutional buyers.
  1. Retained earnings are the profits of past years kept in the business instead of being distributed. How much a company retains depends on the profit it earns, its dividend policy, its age, its future plans and the conditions prevailing in the capital market.
  2. Retention costs nothing to arrange, creates no charge on assets and disturbs no control, but money obtained without cost may be used carelessly, continued retention can lead to over-capitalisation and to dissatisfaction among shareholders, and profits are too uncertain to be relied upon.
  3. Debentures represent the loan capital of a company. The debentureholder is a creditor entitled to interest whether or not profits are earned, has no vote, is usually secured by a fixed or floating charge and is repaid on the date fixed. Debentures may be naked or mortgage, redeemable or irredeemable, bearer or registered, and convertible or non-convertible.
  4. Debentures are economical, carry relief in tax, leave control undisturbed and allow the company the benefit of trading on equity, but they fasten a permanent burden of interest, charge the assets and lower the credit standing of the company.
  5. Commercial banks grant term loans for medium and long periods against security or a personal guarantee. The specialised financial institutions set up by the Government provide loan capital and risk capital alike, are open to new concerns and give technical and managerial guidance, but they investigate the project thoroughly and may nominate directors and convert their loans into equity.
  6. Short-term needs are met by assistance from commercial banks — loans and advances, cash credit, bank overdraft and the discounting of bills — and by public deposits, trade credit, customer advances, factoring, inter-corporate deposits and instalment credit.
  7. Every source is a bargain. What it costs the company is measured not only by the return it promises, but by the security it takes and the control it demands, and the source chosen for any purpose should match the length of the need it is meant to serve.

Table 3.7 — Each Source Against The Need It Serves | Source | Owned or borrowed | Period served | What the supplier of funds receives | |—|—|—|—| | Equity shares | Owned | Permanent | Residual profits and control of the company | | Preference shares | Owned | Long-term | A fixed dividend before equity, and priority in repayment | | Retained earnings | Owned | Permanent | Nothing paid out, but a holding of growing value | | Debentures | Borrowed | Long-term | Fixed interest, security and a date of repayment | | Loans from banks and institutions | Borrowed | Medium and long-term | Fixed interest and a charge on the assets | | Public deposits | Borrowed | Short and medium-term | Interest above the bank rate, without any security | | Trade credit | Borrowed | Short-term | Payment of the invoice on a later date | | Customer advances | Borrowed | Short-term | Delivery of the goods booked | | Factoring | Sale of an asset | Short-term | The book debts, bought at a discount | | Inter-corporate deposits | Borrowed | Short-term | Interest, on the strength of reputation alone | | Instalment credit | Borrowed | Short-term | Interest with each instalment, and ownership until paid |

3.10 Points To Ponder

  1. A promoter who is unwilling to lose control can raise his money through preference shares and debentures rather than equity shares, and the company stays in his hands. Both, however, carry a claim on the profits that must be met before anything reaches him. At what point does the burden of keeping control cost more than the control is worth, and does the answer change with how steady the company’s earnings are?

  2. Retained earnings cost nothing to raise, but the money belongs to the shareholders, who are not asked whether they would rather have it. Should the management be free to decide by itself how much of its shareholders’ profit to keep back, or does a shareholder who bought the shares for an income have a fair claim to be paid?

  3. A debentureholder or a bank, who takes the smaller risk, insists on security over the assets, while an equity shareholder, whose money is exposed to every risk of the business, is given none. Why should protection go to the party that needs it least, and what does it mean for the shareholders of a company that has already charged all its assets to its lenders?

  4. No interest appears on an invoice bought on credit, and a firm that always takes the full credit period seems to be financing its stock for nothing. Set against that the higher price charged on credit purchases and the cash discount that is forgone. Is trade credit as cheap a source as it looks, and how should a firm decide whether to pay at once instead?

  5. A financial institution that lends to a company nobody else will finance may ask, in return, for its own nominees on the Board and for the right to convert its loan into equity shares. Is that a reasonable price for money that would otherwise not have been available, or does it take from the company the very independence it was formed to have?

3.11 Objective Questions

  1. Fully paid shares issued free of charge to existing shareholders by capitalising accumulated profits are called: [1]
  1. rights shares
  2. sweat equity shares
  3. bonus shares
  4. redeemable preference shares
  1. Interest on debentures is: [1]
  1. an appropriation of profit, payable only when profits are earned
  2. a charge against profit, payable whether or not profits are earned
  3. payable at the discretion of the Board of Directors
  4. payable only at the time of redemption
  1. Assertion (A): The issue of preference shares does not ordinarily disturb the control of the existing shareholders. Reason (R): Preference shares carry no voting rights in the normal course. [1]
  1. Both (A) and (R) are true, and (R) is the correct explanation of (A).
  2. Both (A) and (R) are true, but (R) is not the correct explanation of (A).
    1. is true, but (R) is false.
    1. is false, but (R) is true.
  1. Fill in the blank: A charge created on the changing assets of a company, such as its stock and book debts, which leaves the company free to deal with them in the ordinary course of business, is called a ______ charge. [1]
  2. State whether the following statement is true or false: A company that raises the whole of its capital by issuing equity shares enjoys the benefit of trading on equity. [1]

3.12 Check Your Concepts

  1. What is meant by a qualified institutional placement? [2]
  2. Distinguish between rights shares and bonus shares on any three bases. [3]
  3. State any three factors that determine the amount of profit a company is able to plough back into the business. [3]
  4. Interest on debentures is a charge against profits, while dividend on preference shares is an appropriation of profits. Explain this statement, and state what it means for a company in a year in which it earns no profit. [4]
  5. Distinguish between equity shares and preference shares on any six points. [6]

3.13 Case-Based Questions

  1. Harith Ceramics Limited has earned a steady profit for nine years and has built up large reserves out of its undistributed profits. It now plans to install a second kiln at considerable cost. The directors are unwilling to issue further equity shares, as the promoters hold only a slight majority of the existing capital. The company also finds that its suppliers of clay and glaze are willing to deliver goods and accept payment sixty days later.
  1. Name the internal source of long-term finance available to Harith Ceramics Limited from the facts stated, and give one reason why its directors may prefer it to a fresh issue of shares. [2]
  2. Name the short-term source of finance described in the last sentence of the case, and state one merit and one demerit of that source. [2]