Unit 4
TYPES OF FINANCING
It is necessary to raise finance from various sources for implementation of the project. The scheme of finance will be determined after consideration of various aspects attached to different sources of finance as following:
- Share capital –preference shares and equity shares
- Debentures
- Term loan from financial institutions
- Unsecured loan-banks, promoters, others.
Promoters Contribution
The persons who are involved in implementation of a project are known as promoters. An entrepreneur who promotes the project is also required to participate in the scheme of finance of the project. The extent of promoter’s contribution in the project is a sign of interest of the involvement the in the project. The promoters contribution can be provided in the form of subscribing to equity and preference shares issued by the company unsecured loans ,seed capital assistance and internal accrual of funds .The bank and financial institution normally participate in the scheme of project finance and they ask the promoters to bring in a certain portion of funds required which is normally between 25% to 50% of the cost of the project into the equity share capital of the company .The promoters contribution can be arranged from outside sources like friends and relatives. For eligibility of the project financing the financial institution may stipulate minimum promoter’s contribution which is to be arranged by the promoters.
Margin money
The banks and financial institutions maintain a margin while financing the project cost. They asked the borrowers to bring a certain amount of the cost of the project cost as margin money to safeguard from the changes in the value of assets that are being financed and provided as a security. The quantum of margin money to depend upon the creditworthiness of the borrower and nature of security provided to the institution. Margin money is one of the important factors which are evaluated by the financial institutions while considering the project for financial assistance. The margin money required for working capital will be provided in the project cost .The RBI guidelines provide the amount of capital brought by the promoters in project financing.
Capital Structure
Capital structure refers to the mix of a firm’s capitalization and includes long-term source of fund such as debentures, preference shares, equity share, and retained earnings. The decision regarding the forms of financing their requirements and their relative proportions in total capitalization are known as capital structure decision. A firm has the choice to raise capital for financing its project from different sources in different proportions as follows:
- Exclusive use of equity capital
- Use of equity and preference capital
- Use of equity and debt capital
- Use of equity, preference and debt capital
- Use of a combination of debt, equity and preference capital in different proportions.
The choice of combination of these sources is called capital structure mix.
Optimum Capital Structure
The theory of optimal capital structure deals with the issue of right mix of debt and equity in the long term capital structure of a firm. This theory states that if a company takes on debt the value of the firm increases up to a point, beyond that point if debt continues to increases then the value of the firm will start to decrease. If the company is unable to repay the debt within the specified period, then it will affect the goodwill of the company in the market. Therefore, the company should select its appropriate capital structure with due consideration to the factors of debt and equity.
Trading on Equity
The term ‘trading on equity’ is derived from the fact that debts are contracted and loans are raised mainly on the basis of equity capital. The concept of trading on equity provides that the capital structure of a company should include equity as well as debt. Again the proportion of debt in the capital structure should also be optimal. Those who provide debt have a limited share in the firm’s earnings and hence want to be protected in term of earning and values represented by equity capital. Since fixed charges do not vary with the firm’s earnings before interest and tax, a magnified effect is produced on earning per share. The determination of optimal level of debt is a formidable task and is a major policy decision. EBIT-EPS analysis is a widely used tool to determine the level of debt in a firm.
Service of Interest and Debts
In order to analyze the borrower’s capacity in payment of interest and debt installment regularly, interest coverage ratios are considered.
Interest Coverage ratio:
The interest coverage shows many times interest charges are covered by funds are available for payment of interest. It is determined as follows:
Interest coverage ratio = PBIT
Interest on Debt
Where, PBIT means profit before interest, and taxes
A very high interest coverage ratio indicates that the firm is conservative in using debt and a very low ratio indicates excessive use of debt. Interest cover indicates how many times a company can its current interest payments out of current profit.
Debt service coverage ratio:
Debt service coverage ratio (DSCR) is the key indicator to the lender to the extent of ability of the borrower to service the loan in regard to timely payment of interest and repayment of loan installment. It indicates whether the business is earning sufficient profit amount. The DSCR is calculated as follows:
DSCR = profit after tax +depreciation +interest on loan
Interest on loan + loan in a year
A ratio of two or more is considered satisfactory by the financial institution. The higher debt service the better debt servicing capacity of the company.
Illustration 1:
Preeti Ltd. Has the following data for projection for the next five years. It has an existing term-long of Rs 360 lakhs repayable over the next 5 years and got sanctions for new term loan for Rs 450 lakhs which is also repayable in 5 years. As a finance manager you are required to calculate;
Interest coverage ratio
Debt service coverage ratio for each of the 5 years and offer your comments.
Rs lakhs
Particulars | 1 | 2 | 3 | 4 | 5 |
Profit after tax | 480 | 575 | 635 | 650 | 685 |
Depreciation | 155 | 150 | 140 | 135 | 120 |
Taxation | 125 | 203 | 254 | 275 | 299 |
Interest on term loans | 162 | 125 | 87 | 50 | 16 |
Repayment of term loans | 178 | 178 | 178 | 178 | 178 |
Solution:
Calculation of interest coverage ratio: (Rs.lakhs)
Particular/years | 1 | 2 | 3 | 4 | 5 | Total |
PBIT | 767 | 903 | 976 | 975 | 1000 | 4621 |
Interest | 162 | 125 | 87 | 50 | 16 | 440 |
Interest coverage | 4.73 | 7.22 | 11.22 | 19.5 | 62.5 | 10.50 |
Calculation of Debt service coverage ratio: (Rs.lakhs)
Particular/years | 1 | 2 | 3 | 4 | 5 | Total |
PAT | 480 | 575 | 635 | 650 | 685 | 3025 |
Depreciation | 155 | 150 | 140 | 135 | 120 | 700 |
Interest on loan | 162 | 125 | 87 | 50 | 16 | 440 |
Total | 797 | 850 | 862 | 835 | 821 | 4165 |
Interest on term loan | 162 | 125 | 87 | 50 | 16 | 440 |
Repayment of term loan | 178 | 178 | 178 | 178 | 148 | 860 |
Total | 340 | 303 | 265 | 228 | 164 | 1300 |
DSCR | 2.34 | 2.81 | 3.25 | 3.66 | 5.00 | 3.20 |
Comments: average interest coverage ratio is 10.50 times and average debt service coverage ratio is 3.20 times. As DSCR is higher than 2 it indicates the better debt serving capacity of the company. Interest coverage ratio is also higher and it indicates that the company is conservative in using its debt.
Illustration 2
BEST ltd is a profit making company heaving paid up capital of Rs 100 lakhs consisting of 10 lakhs ordinary share Rs 10 each. Currently it is earning an annual pre-tax profit of Rs 60 lakhs. The company’s shares are listed on BSE and are quoted in the range of Rs 50 to Rs 80. The management wants to diversify production and has approved a project which will cost Rs. 50 lakhs and which is expected to yield a pre-tax profit of Rs. 40 lakhs per annum. To raise this capital, the following options are under consideration of the management:
- To issue equity capital for the entire additional amount. It is expected that the new shares (face value of Rs. 10) can be sold at a premium of Rs.15 each.
- To issue 16% non-convertible debentures of Rs.100 each for the entire amount.
- To issue equity capital of Rs.25 lakhs (face value of Rs 10) and 16% non-convertible debentures foe the balance amount. In this case, the company can issue shares at a premium of Rs.40 each.
You are required to advise the management as to how the additional capital can be raised; keeping in mind the management wants to maximize the earnings per share to maintain its goodwill. The company is paying income tax at 30%.
Solution:
(a) Calculation of earnings per share under the three options:
| Option I (Rs lakhs ) | Option II (Rs lakhs ) | Option III (Rs lakhs ) |
Estimated total income |
|
|
|
(i) current operations | 60 | 60 | 60 |
(ii) new operations | 40 | 40 | 40 |
PBIT | 100 | 100 | 100 |
Less: interest on 16%debenture | - | 8 | 4 |
Profit before tax | 100 | 92 | 96 |
Less :tax @ 30% | 30 | 27.60 | 28.80 |
Profit after tax | 70 | 64.40 | 67.20 |
Number of equity shares(lakhs) | 12 | 10 | 10.50 |
EPS | 5.83 | 6.44 | 6.4 |
Earnings per share can be maximized with option. II. Hence, it is advised to issue 16% debentures, is the most suitable.
What is the main purpose of business finance? or Why is finance so important?
The need and importance of business finance may be explained as follows:
1. Establishment of Business Enterprises
Finance is required for the promotion of the establishment of any type of enterprise. Finance is required for registration of the company, for incorporation, for obtaining the certificate for starting the business and also for obtaining permission letter.
Besides, expenditure on these requirements, finance is required for arranging the working place, machinery, and equipment, working material, furnishing and salaries of the employees.
Thus, finance is required to complete the initial activities of the business enterprise.
2. Efficient Operation of Business
Finance is the source of business, which cannot be efficiently operated without finance, the reason being that with the help of Finance, purchase of commodities and raw materials, sending of products to the consumers, conversion of raw materials into finished product and sale thereof become possible.
3. Development and Extension of Business
Finances are also required for the development and extension of all business activities of the modern age. With finances, various commodities may be purchased or sold or produced. Besides, finance (capital) is also required for the purchasing of techniques, machinery, and equipment, the establishment of Laboratories, etc.
4. Sound Business Position
Finance is the only base point by which sound or weak position of business is known, reason being that payments may be made easier to the suppliers, remuneration and facilities may be provided to the Employees and payment of original amount and interest may be paid to the debtors in time, only when sufficient funds are available. Not only that, but other responsibilities may also be performed easily.
5. Facing Competition
Advertisement and publicity production and distribution of new commodities and services, incentives to the consumers, sale promotion, providing services and commodities at a fair price are required, to face present-day competitors. For all these activities, finances are required.
6. For Infrastructural Facilities
Finance is also required for arranging those infrastructural facilities which are essential for business entrepreneurship, although the volume of required finances may be high or low, according to the coverage of various Enterprises.
Substantial capital is required for all infrastructural facilities, place, land, office site, plant installation for the establishment of industries, place for conversion of raw materials into finished products, water, electricity, telephone, etc.
7. Modernization of Business
Finances are required for new techniques, new sources, new machinery, various new products, and computerization, which are essential for the modernization and operation of the business.
Not only that, finance is required for Business location, furnishings of its office, etc.
8. For Marketing Expenses
In the modern age, marketing is an important function of business, the reason being the area of marketing has become quite wide and that has necessitated various activities, like – advertising and publicity, sales promotion, marketing mix, selection of marketing intermediaries, distribution of goods, transportation, warehousing and marketing research, etc. For all these activities, finances important needful role for every business.
9. Labour Welfare and Social Security
For the success of any business or enterprise, human relations between employers and workers should be cordial. For that, the entrepreneurs should essentially safeguard the interests of the employees and workers. For that, they are to be provided with various facilities, like – that of housing, primary treatment, health, education, libraries, and reading rooms, travel, etc.
In addition, they are also to be provided provident fund, gratuity, pension, old age, personal or group insurance and accidental insurance, etc. All these need a substantial volume of finance. Otherwise, it may not be possible to provide all these facilities.
10. Other Needs and Importance
Business Finance is required for research and development, international trade and the success of various schemes for Industrial and business development.
Business simply cannot function without money, and the money required to make a business function is known as business funds. Throughout the life of business, money is required continuously. Sources of funds are used in activities of the business. They are classified based on time period, ownership and control, and their source of generation.
On the basis of Period
Long Term Sources | Medium Term Sources | Short Term Sources |
Equity Shares | Loan from Banks | Trade Credit |
Retained Earnings | Public Deposits | Factoring |
Preference Shares | Loans from Financial Institution | Banks |
Debentures | Etc | Commercial Paper |
Loans from Financial Institution |
| Letter of Credit |
Etc |
| Etc |
On the basis of Ownership
Owners Funds | Borrowed Funds |
Equity Shares | Debentures |
Retained Earnings | Loans from Financial Institution |
| Loan from Banks |
| Public Deposits |
| Lease Financing |
On the basis of Source of Generation
Internal Sources | External Sources |
Equity Shares | Debentures |
Retained Earnings | Loans from Financial Institution |
| Loan from Banks |
| Public Deposits |
| Lease Financing |
| Trade Credit |
| Factoring |
| Banks |
| Commercial Paper |
| Letter of Credit |
There are different sources of funds available to meet long- term financial needs of the business. These sources may be broadly classified as under:
- Share capital.
- Debentures or bonds.
- Retained earnings.
- Loans from financing institutions.
- Loans from commercial banks.
- Share capital:
A public limited company can raise capital from issue of shares to the public. It is called public issue of shares. A private company can raise capital by issue of shares to the friends and relatives but not from the public through public issue. Share capital is the owner’s capital. Every company can raise capital by issue of shares. Partnership and sole traders cannot issue shares. Public limited companies can raise any amount of capital by issue of shares because there is no limit on the maximum number of shareholder’s or members. There are two types of shares.
- Preference shares:
Preference shares are those shares which have first preference for payment of dividend and refund of capital at the time of winding up of the company, long – term funds can be revised by public limited companies through a public issue of share. The preferences carry a fixed rate of dividend. If the stock market, it can raise capital by issue of preference shares for raising long – term funds. Preference shares are normally cumulative i.e. the dividend payable in a year of loss gets carried over to the next year till there are adequate profits to pay the cumulative dividends. The companies act, 1956 provides that “no profit, no dividend”.
Preference share capital is a hybrid form of financing because it possesses some characteristics of equity capital and some attributes of debt capital. Preference shares may be convertible which can be converted into equity share after a certain period. These shares can also be redeemable at a certain period. This enables the gained importance after the finance bill, 1997 as dividends became tax free in the hands of the individual investors and are taxable in the hands of the company as a tax on dividend distribution.
II. Equity or ordinary shares:
Ordinary shares are those shares which are not preference shares. Ordinary shares are a source of permanent capital. Ordinary shares are owners of company and they undertake the risks of the business. They are entitled to dividends after the income claims of others stakeholders are satisfied. Similarly, in the event of winding up, ordinary shareholders’ can exercise their claim on assets after the claim of the other suppliers of capital have been met. They elect the directors to run and manage the business of the company. The cost of equity shares is usually highest. This is due to the fact that the shareholders expect a higher rate of return on their investment as compared to other suppliers of long – term funds. Thus, ordinary shareholders’’ carry a higher amount of risk and so expect a higher return. A company having substantial ordinary share capital may find it easier to raise funds, in view of the fact that share capital provides a security to other suppliers of funds.
b. Debenture or Bonds:
Issues of debentures or bonds are sources of borrowed capital. It is a source of long – term capital. A debenture is an acknowledgement of debt issued by a company. Normally the debentures are issued by the public limited companies in private sector. However, bonds are issued by the government companies a public sector undertaking. Debentures a bond are issued in different denomination ranging from Rs 100 to Rs 1000 and carry different rate of interest. a company has to make public issue for issuing Debenture or bonds. It is just like issue of share . The Debenture are also traded in stock market. Thus, Debentures provides a more convenient mode of long – term funds. The cost of capital through Debenture is quite low because the interest payable on Debenture can be charged as an expense before tax. From the investor’s point of view, Debenture offer a more attractive prospect than the preferences share since, interest on debenture is payable, whether or not the company makes profit.
Debentures in India are considered as secured loan. They are protected by a charge on the assets of the company. The Debenture can also be convertible Debenture. They are partly convertible or fully convertible into share of a company. Debentures are converted into equity share as per the term of the issue in relation to price and the time conversion. Interest on debenture is fixed at a time of issue and interest convertible debenture is generally lower than the non-convertible debenture. Indian companies have been issuing convertible debenture or bonds with a number of schemes, options, and incentives like warrants etc. The issue of convertible debentures has distinct advantage from the point of view of the issuing company. Such an issue enables the management to raise the equity capital indirectly diluting the equity holding until the capital raise has started earning an added return to support the additional shares such securities can also be issued even when the equity market is not very good convertible bonds are normally unsecured and, therefore, there issuance may ordinary not impair the borrowing capacity. The debentures or bonds are issued subject to the SEBI guidelines. Public issues of debentures now require that the issue be rated by a credit rating agency. The credit rating is given after evaluating factor like track record if the company, profitability debt servicing capacity, credit worthiness and perceived risk of landing.
c. Long term Loan from financial institution:
Long term loans are provided by specify financial institutions in India. The following are the specialised financial institution:
- The industrial financial corporation in India.
- Industrial development bank of India.
- Industrial Reconstruction Corporation in India.
- Small industries development bank of India.
- Life insurance Corporation of India.
- State financial corporation.
- Exime book.
Term loans are provided by these institutions at different rate of interest under scheme of financial institution. It is also to be repaid according to a stipulated repayment schedule these institutions stipulate a number of condition management and certain and other financial policy of a company.
Term loan represent secured borrowing. It is the most important source of finance for new project. They generally carry a rate of interest inclusive interest tax depending on the credit rating of the borrower, the perceived risk of lending. The loan are generally repayable over a period of 60 to 10 years in annul, half yearly or quarterly installment. For last scale project all India financial institution provide the bulk of term finance either singly or in consortium with other financial institution.
d. Loan from commercial banks:
The banks’ in India also provide term loans to the companies. Banks normally provides term loans to projects in the small and medium scale sectors. The primary role of commercial banks is to cater to the short term requirement of the industry. However, banks have started taking an interest on term financing of industries in several ways. The proceeds of the term loan from banks are generally used for fixed assets or for expansion of plant capacity. Their repayment is scheduled over a period of time. Term loans proposals involve an element of risk because of changes in the conditions affecting the borrowers. The bank making such a proposal has to access the situation to make a proper appraisal. The decision in such a situation would depend upon various factors affecting the conditions of the industry concerned and the earning potential of the borrower.
e. Retained earnings:
Retained earnings are the profits retained in the business. Every company retains certain portion every year in the form of reserve. Even the balance of profit after declaration of dividend is also carried forward in the balance of sheet. It is known as ploughing backs of profits. Such funds belong to the ordinary shareholder’s and increase the net worth of company. a public limited company has to plough back a reasonable amount of profit every year keeping in view the legal requirements and its own expansions plans. However, retained earnings can be used by existing and financially sound companies. A new company or a loss making company cannot follow this method. Retained earnings are used as a long-term capital without any cost.
- Indigenous Bankers
Private money-leaders and other country bankers used to be the only sources of finance prior to the establishment of commercial banks. They used to charge very high rates of interest and exploited the customers to the largest extent possible.
Now-a-days with the development of commercial banks they have lost their monopoly. But even today some business houses have to depend upon indigenous bankers for obtaining loans to meet their working capital requirements.
2. Trade Credit
Trade credit refers to the credit extended by the suppliers of goods in the normal course of business. As present day commerce is built upon credit, the trade credit arrangement of a firm with its suppliers is an important source of short-term finance. The credit-worthiness of a firm and the confidence of its suppliers are the main basis of securing trade credit.
It is mostly granted on an open account basis whereby supplier sends goods to the buyer for the payment to be received in future as per terms of the sales invoice. It may also take the form of bills payable whereby the buyer signs a bill of exchange payable on a specified future date.
When a firm delays the payment beyond the due date as per the terms of sales invoice, it is called stretching accounts payable. A firm may generate additional short-term finances by stretching accounts payable, but it may have to pay penal interest charges as well as to forgo cash discount.
If a firm delays the payment frequently, it adversely affects the creditworthiness of the firm and it may not be allowed such credit facilities in future.
The main advantages of trade credit as a source of short-term finance include:
(i) It is easy and convenient method of finance.
(ii) It is flexible as the credit increases with the growth of the firm.
(iii) It is informal and spontaneous source of finance.
However, the biggest disadvantage of this method of finance is charging of higher prices by the suppliers and loss of cash discount.
3. Installment Credit
This is another method by which the assets are purchased and the possession of goods is taken immediately but the payment is made in Installment over a pre-determined period of time. Generally, interest is charged on the unpaid price or it may be adjusted in the price.
But, in any case, it provides funds for sometimes and is used as a source of short-term working capital by many business houses which have difficult funds position.
4. Advances
Some business houses get advances from their customers and agents against orders and this source is a short-term source of finance for them. It is a cheap source of finance and in order to minimize their investment in working capital, some firms having long production cycle, especially the firms manufacturing industrial products prefer to take advance from their customers.
5. Factoring:
Another method of raising short-term finance is through account receivable credit offered by commercial banks and factors. A commercial bank may provide finance by discounting the bills or invoices of its customers. Thus, a firm gets immediate payment for sales made on credit.
A factor is a financial institution which offers services relating to management and financing of debts arising out of credit sales. Factoring is becoming popular all over the world on account of various services offered by the institutions engaged in it.
Factors render services varying from bill discounting facilities offered by commercial banks to a total take-over of administration of credit sales including maintenance of sales ledger, collection of accounts receivables, credit control and protection from bad debts, provision of finance and rendering of advisory services to their clients.
Factoring may be on a recourse basis, where the risk of bad debts is borne by the client, or on a non-recourse basis, where the risk of credit is borne by the factor.
At present, factoring in India is rendered by only a few financial institutions on a recourse basis. However, the Report of the Working Group on Money Market (Vaghul Committee) constituted by the Reserve Bank of India has recommended that banks should be encouraged to set up factoring divisions to provide speedy finance to the corporate entities.
6. Accrued Expenses
Accrued expenses are the expenses which have been incurred but not yet due and hence not yet paid also. These simply represent a liability that a firm has to pay for the services already received by it. The most important items of accruals are wages and salaries, interest, and taxes.
Wages and salaries are usually paid on monthly, fortnightly or weekly basis for the services already rendered by employees. The longer the payment- period, the greater is the amount liability towards employees or the funds provided by them.
In the same manner, accrued interest and taxes also constitute a short-term source of finance. Taxes are paid after collection and in the intervening period serve as a good source of finance. Even income-tax is paid periodically much after the profits have been earned. Like taxes, interest is also paid periodically while the funds are used continuously by a firm. Thus, all accrued expenses can be used as a source of finance.
The amount of accruals varies with the change in the level of activity of a firm. When the activity level expands, accruals also increase and hence they provide a spontaneous source of finance. Further, as no interest is payable on accrued expenses, they represent a free source of financing. However, it must be noted that it may not be desirable or even possible to postpone these expenses for a long period.
The payment period of wages and salaries is determined by provisions of law and practice in industry. Similarly, the payment dates of taxes are governed by law and delays may attract penalties. Thus, we may conclude that frequency and magnitude of accruals is beyond the control of managements. Even then, they serve as a spontaneous, interest free, limited source of short-term financing.
7. Deferred Incomes
Deferred incomes are incomes received in advance before supplying goods or services. They represent funds received by a firm for which it has to supply goods or services in future. These funds increase the liquidity of a firm and constitute an important source of short-term finance.
However, firms having great demand for its products and services, and those having good reputation in the market can demand deferred incomes.
8. Commercial Paper
Commercial paper represents unsecured promissory notes issued by firms to raise short-term funds. It is an important money market instrument in advanced countries like U.S.A. In India, the Reserve Bank of India introduced commercial paper in the Indian money market on the recommendations of the Working Group on Money Market (Vaghul Committee).
But only large companies enjoying high credit rating and sound financial health can issue commercial paper to raise short-term funds. The Reserve Bank of India has laid down a number of conditions of determine eligibility of a company for the issue of commercial paper.
Only a company which is listed on the stock exchange has a net worth of at least Rs. 10 crores and a maximum permissible bank finance of Rs. 25 crores can issue commercial paper not exceeding 30 per cent of its working capital limit.
The maturity period of commercial paper, in India, mostly ranges from 91 to 180 days. It is sold at a discount from its face value and redeemed at face value on its maturity. Hence, the cost of raising funds through these sources is a function of the amount of discount and the period of maturity and no interest rate is provided by the Reserve Bank of India for this purpose.
Commercial paper is usually bought by investors including banks, insurance companies, unit trusts and firms to invest surplus funds for a short-period. A credit rating agency, called CRISIL, has been set up in India by ICICI and UTI to rate commercial papers.
Commercial paper is a cheaper source of raising short-term finance as compared to the bank credit and proves to be effective even during period of tight bank credit. However, it can be used as a source of finance only by large companies enjoying high credit rating and sound financial health.
Another disadvantage of commercial paper is that is cannot be redeemed before the maturity date even if the issuing firm has surplus funds to pay back.
9. Commercial Banks
Commercial banks are the most important source of short-term capital. The major portion of working capital loans are provided by commercial banks. They provide a wide variety of loans tailored to meet the specific requirements of a concern.
The different forms in which the banks normally provide loans and advances are as follows:
(a) Loans:
When a bank makes an advance in lump-sum against some security it is called a loan. In case of a loan, a specified amount is sanctioned by the bank to the customer. The entire loan amount is paid to the borrower either in cash or by credit to his account. The borrower is required to pay interest on the entire amount of the loan from the date of the sanction.
A loan may be repayable in lump sum or installments. Interest on loans is calculated at quarterly rests and where repayments are stipulated in installments, the interest is calculated at quarterly rests on the reduced balances.
Commercial banks generally provide short-term loans up to one year for meeting working capital requirements. But, now-a-days, term loans exceeding one year are also provided by banks. The term loans may be either medium-term or long-term loans.
(b) Cash Credits:
A cash credit is an arrangement by which a bank allows his customer to borrow money up to a certain limit against some tangible securities or guarantees. The customer can withdraw from his cash credit limit according to his needs and he can also deposit any surplus amount with him. The interest in case of cash credit is charged on the daily balance and not on the entire amount of the account.
For these reasons, it is the most favourite mode of borrowing by industrial and commercial concerns. The Reserve Bank of India issued directive to all scheduled commercial banks on 28th March 1970, prescribing a commitment charge which banks should levy on the unutilised portion of the credit limits.
(c) Overdrafts:
Overdraft means an agreement with a bank by which a current account-holder is allowed to withdraw more than the balance to his credit up to a certain limit. There are no restrictions for operation of overdraft limits.
The interest is charged on daily overdrawn balances. The main difference between cash credit and overdraft is that overdraft is allowed for a short period and is a temporary accommodation whereas the cash credit is allowed for a longer period. Overdraft accounts can either be clean overdrafts, partly secured or fully secured.
(d) Purchasing and Discounting of Bills:
Purchasing and discounting of bills is the most important from in which a bank lends without any collateral security. Present day commerce is built upon credit. The seller draws a bill of exchange on the buyer of goods on credit. Such a bill may be either a clean bill or a documentary bill which is accompanied by documents of title to goods such as a railway receipt.
The bank purchases the bills payable on demand and credits the customer’s account with the amount of bills less discount. At the maturity of the bills, bank presents the bill to its acceptor for payment. In case the bill discounted is dishonoured by non-payment, the bank recovers the full amount of the bill from the customer along with expenses in that connection.
In addition to the above mentioned forms of direct finance, commercial banks help their customers in obtaining credit from their suppliers through the letter of credit arrangement.
(e) Letter of Credit:
A letter of credit popularly known as L/C is an undertaking by a bank to honour the obligation of its customer up to a specified amount, should the customer fail to do so. It helps its customers to obtain credit from suppliers because it ensures that there is no risk of non-payment.
L/C is simply a guarantee by the bank to the suppliers that their bills up to a specified amount would be honoured. In case the customer fails to pay the amount, on the due date, to its suppliers, the bank assumes the liabilities of its customer for the purchases made under the letter of credit arrangement.
A letter of credit may be of many types, such as:
(i) Clean Letter of Credit:
It is a guarantee for the acceptance and payment of bills without any conditions.
(ii) Documentary Letter of Credit:
It requires that the exporter’s bill of exchange be accompanied by certain documents evidencing title to the goods.
(iii) Revocable Letter of Credit:
It is one which can be withdrawn by the issuing bank without the prior consent of the exporter.
(iv) Irrevocable Letter of Credit:
It cannot be withdrawn without the consent of the beneficiary.
(v) Revolving Letter of Credit:
In such type of letter of credit the amount of credit is automatically reversed to the original amount after such an amount has once been paid as per defined conditions of the business transaction. There is no deed for further application for another letter of credit to be issued provided the conditions specified in the first credit are fulfilled.
(vi) Fixed Letter of Credit:
It fixes the amount of financial obligation of the issuing bank either in one bill or in several bills put together.
Security Required in Bank Finance:
Banks usually do not provide working capital finance without obtaining adequate security.
The following are the most important modes of security required by a bank:
(i) Hypothecation:
Under this arrangement, bank provides working capital finance against the security of movable property, usually inventories. The borrower does not give possession of the property to the bank. It remains with the borrower and hypothecation is merely a charge against property for the amount of debt. If the borrower fails to pay his dues to the bank, the banker may file a case to realise his dues by sale of the goods/property hypothecated.
(ii) Pledge:
Under this arrangement, the borrower is required to transfer the physical possession of the property of goods to the bank as security. The bank will have the right of lien and can retain the possession of goods unless the claim of the bank is met. In case of default. The bank can even sell the goods after giving due notice.
(iii) Mortgage:
In addition to the hypothecation or pledge, banks usually ask for mortgages as collateral or additional security. Mortgage is transfer of a legal or equitable interest in a specific immovable property for the payment of a debt.
Although, the possession of the property remains with the borrower, the full legal title is transferred to the lender. In case of default, the bank can obtain decree from the Court to sell the immovable property mortgaged so as to realise its dues.
10. Public Deposits:
Acceptance of fixed deposits from the public by all type of manufacturing and non-bank financial companies in the private sector has been a unique feature of Indian financial system. The importance of such deposits in financing of Indian industries was recognised as early as in 1931 by the Indian Central Banking Enquiry Committee.
It has been most common in the financing of cotton textile industry in Bombay and Ahmedabad, but in the recent years many companies have accepted deposits from the public to finance their working capital requirements.
The manifold increase in demand for public deposits from the corporate sector in India has been on account of restrictive credit policy of the Govt. Of India and a substantial credit gap existing in the market.
As a result, companies have been accepting deposits directly from the public by offering higher rates of interest as compared to banks and post offices to meet their requirements of funds. But even by offering higher rates of interest to the investors, the cost of funds raised through public deposits to the companies has been lower than the minimum rate of interest on bank advances.
In spite of the fact that public deposits are unsecured, more risky, less liquid and without any tax advantage, there has been a tremendous growth both in the amount of public deposits as well in the number of companies accepting such deposits. The number of people making investment in public deposits has also increased manifold.
The public sector (Government Companies) has also started accepting public deposits since June, 1980. According to an estimate, over Rs. 3,000 crores have been invested by way of public deposits in the corporate sector. The study of the tenure of public deposits in various companies shows that about 80 per cent of the deposits were of short nature during 1960s.
But since then the maturity period of the such deposits has been lengthening and about 90 per cent of the deposits were for maximum period of 36 months during the latter half of 1980s. If an industry wise analysis is made, we find that companies engaged in heavy engineering, iron and steels, cotton textiles, cement and chemicals accounted for a large share of public deposits.
Acceptance of public deposits by the corporate sector, in many cases, has been found to encourage non-priority sectors of production and defeat the very purpose of the restrictive credit policy of the Reserve Bank of India.
The growth of public deposits in companies has also been viewed as diversion of people’s savings in the non-banking sector. However, this view has been disputed by many thinkers who think that “eventually these company deposits would find their way into the banking system via tax payments, payments to creditors”, etc.
Since January 1967, the Government of India has tried to restrict the growth of company deposits through various measures. The primary objective of exercising control over public deposits has been to regulate the growth of deposits outside the banking sector as well as to provide some protection to the investors in such deposits.
But, in spite of the restrictive measures, public deposits with the non-banking corporate sector have become a significant part of corporate financing.
The sources from which a business meets its financial requirements can be classified according to the period, ownership and source of generation. The sources of funds according to the period, under long-term sources of funds such as shares, debentures and term loans and short-term, sources such as public deposits, advances from customers and trade creditors. According to ownership the share capital and retained earnings are owned sources. While debentures and term loans are borrowed funds.
According to source of generation, internal are retained earnings and funds and external sources such as shares and debentures or term loans.
For the sake of convenience, the different sources of funds can be classified into the three categories. These categories are security financing, internal financing and loan financing. A large number of specialized financial institutions have been set up in the country after independence to meet the specific term financial needs of the companies. They are popularly known as development banks. Development banks seek to mobilize scarce resources, such as capital, technology, managerial and entrepreneurial talents and canalize them into industrial activities in accordance with plan priorities .it has, therefore, to share its policies, procedures and function in way do as to cater to development needs of specified sectors as well as economy in general.
Institutional considerations are provided on the basis of type of loan, period and their priorities. The considerations are given below:
- Certain institutions provide any short term loan such as SIDBI and state financial corporation.
2. The IFCI financials assistance for setting up new industrial projects m renovation, modernization, expansion and diversification etc.
3. IDBI was established to provide direct assistance scheme which included project m renovation, modernization, technical development fund scheme and equipment finance schemes.
4. The objective of the unit trust of India was to stimulate and pool the saving of the middle class and low income group and to enable them to share the benefits and the prosperity of the rapidly growing industrial; of the country.
5. The Exim bank was setup on 1st January 1982, for financing and promoting export and for coordinating working of other financial institution engaged in the export -import financing.
6. Infrastructure development finance company Ltd was conceived as an institution that take the lead in providing capital to commercially viable infrastructure project in India.
7. Loans indication involves commitment them term loan from the financial institution and banks for financing a particular project. Two or more financial institution or banks agree to finance a particular project. One of the institutions may become institution and bring about coordinator in the financing arrangement.
8. When the individual bank finds it difficult to meet the huge financial requirement of a borrower, it give rights to multiple banking which may be form “consortium lending “.
9. Bridge loans are available from the bank and financial institution when the sources and timing of the funds to raised is known with certainty. Where there is a time gape for excess of fund, then for speeding up of implementation of the project bridge loan provided such loans are repaid immediately after the raising of funds.
10. Non–recourse financing; traditionally, the debt component of the standard project finance project has been of the full – resource warily the development finance institutions have full recourse to even non- project-related assets as finance is extended either on the basis of the overall strength of the balance sheet of the company or on the basis or guarantee of other sources of company.