Financial Management

BSPATIL 1
UNIT 1
Financial Management
Nature of Scope of Financial Management
During the past three decades role and responsibilities of finance manager have undergone a marked
transformation ever witnessed earlier. The finance manager has now become an integral part of the
business enterprise and is involved in all the activities that take place in the enterprise. Until recently,
finance executive was considered as keeper of books of accounts and provider of funds needed by the
firm. But today his responsibility is not limited ot procurement of funds but extends beyond it to ensure is
optimal utiliation. !e plays pivotal role in planning "uantum and pattern of fund re"uirements, procuring
the desired amount of funds. #ince all the business activities like marketing, purchase and production
involve cash planning and utiliation or generation of funds, the finance manager must take cogniance of
his involvement in all the activities of the firm. !e must also have clear conception of the overall ob$ective
of his firm as he has to act in conformity lea with the ob$ective. %urthermore, he has to evaluate the
effectiveness of financial decisions in the light of some standard ob$ectives of the firm.
OBJETI!E OF T"E FI#M
&b$ectives are long'term purpose and mission, which state the reason for existence of the firm and declare
what it wants to achieve in the long run. They represent desired results, the firm wishes to attain by its
existence arid operations. They indicate specific sphere of aims, activities and accomplishment.
Being profit seeking organiation, the management is supposed to set profit maximiation as the ob$ectives
and accomplishment.
P#OFIT MA$IMI%ATION OBJETI!ES
(rofitability ob$ective may be stated in terms of profits, return on investment, or profit'to sales ratios.
)ccording to this ob$ectives, all such actions as increase income and cut down costs should be undertaken
and those that are likely to have adverse impact on profitability of the enterprise should be avoided.
)dvocates of the profit maximiation ob$ective are of the view that this ob$ectives is simple and has the
inbuilt advantage of $udging economic performance of the enterprise. %urther, it will direct the resources in
those channels that promise maximum return. #ince the finance manager is responsible for the efficient
utiliation of capital, it is plausible to pursue profitability maximiation as the operational standard to test
the effectiveness of financial decisions.
!owever, profit maximiation ob$ective suffers from several drawbacks, rendering it as an ineffective
decisional criterion. These drawbacks are*
&1' It i( )ague
)mbiguity of the term profit as used in the profit maximiation ob$ective is its first weakness.
+t is not clear in what sense the term profit has been used. +t may be total profit before tax or after tax or
profitability rate. ,ate of profitability may again be in relation to share capital, owner-s funds, total capital
employed or sales. .hich of these variants of profit maximiation ob$ective to be considered remains
vague/ %urthermore, the word profit does not speak anything about short'term and long'term profit. ) firm
can maximie its short'term profit by avoiding current expenditures on maintenance of a machine. But
owing to this neglect, the machine being put to use may no longer be capable of operating after some time
with the result that the firm will have to defray huge investment outlay to replace the machine. Thus, profit
BSPATIL 0
maximiation suffers in the long run for the sake of maximiing short'term profit. &bviously, long'term
consideration of profit cannot be neglected in favour of short'term profit.
&*' It ignore( time( )alue factor
(rofit maximiation ob$ective fails to provide any idea regarding timing of expected cash earnings. %or
instance, it there are two investment pro$ects and suppose one is likely to produce streams of earnings of
,s. 12,222 in sixth year from not and the other is likely to produce annual benefits of ,s. 13,222 in each of
he ensuring six years both the pro$ects cannot be treated as e"ually useful ones although total benefits of
both the pro$ects are identical because of differences in value of benefits received today and those
received a year or two years after. 4hoice of more worthy pro$ects lies in the study of time value of future
inflows of cash earnings. The interest of the firm and its owners is affected by the time value factor. (rofit
maximiation ob$ective does not take cogniance of this vital factor and treats all benefits, irrespective of
the timing, as e"ually valuable.
&+' It ignore( ri(, factor
)nother serious shortcoming of the profit maximiation ob$ective is that it overbooks risk factor. %uture
earnings of different pro$ects are related with risks of varying degrees. !ence, different pro$ects may have
different values even though their earnings capacity is the same. ) pro$ect with fluctuating earnings is
considered more riskier thatn the one with certainty of earnings. 5aturally in investor would provide less
value to the former than to the latter. ,isk element of pro$ect is also dependent on the financing mix of the
pro$ect. (ro$ect largely financed by way of debt is generally more riskier than the one predominantly
financed by means of share capital.+t view of the above, the profit maximiation ob$ective is inappropriate
and unsuitable as an operational ob$ective of the firm. #uitable and operationally feasible ob$ective of the
firm should be precise and clear cut and should give weightage to time value and risk factors. )ll these
factors are well taken care of by wealth maximiation ob$ective, which we shall discuss, in the following
paragraphs.
-EALT" MA$IMI%ATION OBJETI!E
.ealth maximiation ob$ective is a widely recognied criterion with which the performance of a business
enterprise is evaluated. The word wealth refers to the net present worth of the firm. Therefore, wealth
maximiation is also stated as net present worth. 5et present worth is the difference between gross
present worth and amount of 4apital investment re"uired to achieve the benefits. 6ross present worth
represents the presents value of expected cash benefits discounted at a rate which their certainly or
uncertainly. Thus, wealth maximiation ob$ective as decisional criterion suggests that any financial action
which creates wealth or which has a net present value above ero is desirable one and should be accepted
and that which does not satisfy this test should be re$ected.
)lgebraically, net present value or worth can be expressed as follows, using 7ra #olomon-s symbols and
models
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.here . 9 net present worth
)1, )0 ..... )n 9 the stream of benefits expected to occur from a course of action over a period of time.
: 9 appropriate discount rate to measure risk and timing
4 9 initial outlay re"uired to ac"uire the asset
The ob$ective of wealth maximiation as pointed out above has the advantage of exactness and
unambiguity and takes care of time value and risk factors.
The wealth maximiation ob$ective when used as decisional criterion serves as a very useful guideline in
taking investment decision. This is because the concept of wealth is very clear. +t represents present value
of the benefits minus the cost of the investment. The concept of cash flow is more precise in connotation
than that of accounting profit. Thus, measuring benefits in terms of cash flows generated avoids ambiguity.
The wealth maximiation ob$ective considers time value of money. +t recognies that cash benefits
emerging from a pro$ect in different years are not identical in value. this is why annual cash benefits of a
pro$ect are discounted at a discount rate to calculate total value of these cash benefits. )t the same time, it
also gives due weightage to risk factor by making necessary ad$ustments in the discount rate. Thus, cash
benefits of a pro$ect with higher risk exposure is discounted at higher discount rate ;cot of capital<, while
lower discount rate is applied to discount expected cash benefits of a less risky pro$ect. +n this way,
discount expected cash benefits of a less risky pro$ect. +n this way, discount rate used to determine present
value of future streams of cash earnings reflects both the time and risk.
+n view of the above reasons, wealth maximiation ob$ective is considered superior to profit maximiation
ob$ective. +t may be noted here that value maximiation ob$ective is simply the extension of profit
maximiation to real life situations. .here the time period is short and magnitude of uncertainly is not gear,
value maximiation and profit maximiation amount to almost the same thing.
.OAL OF FINANIAL MANA.EMENT
6oals of financial management should be so articulated as to help achieve the ob$ective of wealth
maximiation. %inancial goals may be stated as maximiing long'term as well as short'term profits and
minimiing risks. These goals imply that the finance manager should take financial decisions in such way
as to ensure high level of profits. !e should also seek courses of action that avoid unnecessary risks and
anticipate problem areas and ways of overcoming difficulties.
+n the pursuit of the above goals, finance manager should recognie the interrelationship between profit
and risk. +n fact, value of a firm is influenced $ointly by return and risk. +n real world, the relationship
between the two is inverse. +nvestments promising high profits will be more riskier than their counterparts.
+t is, therefore, the prime responsibility of the finance manager to strike $udicious balance between return
and risk in order to maximie value of the firm. To assure maximum profits to the firm, the finance manager
must monitor the cash inflows and outflows of the business and thereby ensure effective utiliation of
resources. !e should also endeavour to build in sufficient flexibility in the financial operations of the
enterprise so as to deal with uncertainty. !e has to gain flexibility by identifying strategic alternatives both
in regard to investment outlets and ac"uisition of funds.
)nother ma$or financial goal of a firm is imparting sufficient li"uidity and profitability of the enterprise. Thus,
a finance manger while managing funds has to ensure that the firm has ade"uate li"uid resources on hand
to satisfy its obligation at all times and in addition it has a certain level above its expected needs to act as a
BSPATIL =
reserve to meet emergencies. But if the firm carries large amount of funds in cash, it losses opportunity
cost of the funds and therefore, goal of high level of profit suffers. ) firm to improve its return must ensure
optimum utiliation of resources. Thus, the finance manager is in dilemma. The dilemma is high profitability
means low li"uidity and, vice'versa. !e must, therefore, strike satisfactory trade off between profitability
and li"uidity.
MANA.EMENT )( O-NE#S
The management of an enterprise is supposed to pursue the ob$ective set for the firm. )lthough they may
not act in the best interests of the owners and pursue its goal to fulfill their ambitions of perpetuating their
control over the enterprise, the possibility of pursuing its personal goals exclusively is remote and limited
because of the constant evaluation of the managerial performance in the light of the overall goal. The
management acting against this goal will not be allowed to continue. %urthermore, in a competitive world, a
company must undertake actions which are reasonably consistent with wealth maximiation goal.
!owever, on certain occasions the interest of the management may clash with that of the owners. Thus, an
entrenched management plays the role of a >satisficer- rather than of a >maximiser-. The term satisficer here
means a person willing to settle for something less. )n entrenched management desirous of perpetuating
its existence for years to come may like to play safe and seek in acceptable level of growth rather than take
the risks to maximie the wealth of stockholders.
+t is cumbersome task to determine when a particular management is playing the role of a satisficer and
when it is acting as maximiser. %or instance, when a risky venture is re$ected because its potential benefits
fall short of its potential costs, how it can be ascertained that decision to re$ect the venture was motivated
by satisficing factor.
+n sum, it can be observed that the management may have other goals but the goal of >maximising owners-
interest is the dominant goal which the management has to persue because more and more firms now'a'
days are tying their compensation to the firm-s performance. 7ven the existence of the management is
linked to the maximiation goal.
SOIAL OBJETI!E
The modern firm has another ob$ectives ? to assume social responsibility. Being a socio'economic organ, a
business enterprise has a responsibility towards various sections of the society. This is necessary not only
because society provides environment conductive to the operation of business enterprise put also for their
survival. 5o organiation can exist any longer without its social acceptance.
) socially responsible enterprise has to conduct its business in a manner that earns recognition as a
constructive and honourable corporate citien in its relation, designed to be mutually profitable with
stockholder, employees, customers, suppliers, community and government.
+t is usually contended that pursuit of social ob$ective interferes with the economic ob$ectives of an
enterprise because social activities will raise costs and risks. )ssumption of social obligations by business
is @ therefore @ likely to weaken its economic vitality of the firm and pose threat to its existence.
The above line of argument emerges from those who ardently believe that economic ob$ects and social
ob$ectives are militant to each other. #ocial obligations increase cost of operations and therefore,
profitability of the enterprise may be adversely affected in the short run but in the long run economic
ob$ectives and social responsibility of business are compatible to each other @ in fact, they reinforce each
other. )s economic organs of society, business enterprises are socially responsible to pursue their profit
BSPATIL 3
making ob$ectives to the optimum extent by meeting the material needs of society. +n fact, the ma$or social
responsibility of a company is to operate profitability and utilie efficiently the resources at its disposal.
#ociety does not gain but loss if business performance suffers.
) business enterprise can serve society only when it operates successfully. (rofit is essential to the
survival of a firm and also to the support of all non'economic activities. Unless a business is able to make a
profit, the "uestion of coping with social responsibilities voluntarily is largely academic. 7conomic
ob$ectives are, in fact, means to the social ends of welfare and public interest.
There would not be any reason to suppose that a socially responsible business will earn less, pay fewer
dividends and achieve appreciation of share price than the one who are only as responsible as the law
re"uires. #ocial activities of a firm may arise cost of business immediately but in the long run it will be
counter balanced by the increased earnings resulting from its social action. Thus, if management decides
to pay higher wages to workers, ensures $ob security and improves working conditions, cost of operations
may go up immediately but increased productivity due to highly motivated workers will reduce per unit cost
of operations. +n the same view, a firm can raise funds from investors at cheaper rate if it has been able to
ensure fair rate of dividends of its owners. #upply of "uality goods at reasonable price will help the firm in
augmenting its sales and improving its earnings because of customers satisfaction.
7ven contribution by business organiations to general welfare programmes have several economic spin'
offs to business. %or example, charitable contributions to social causes tend to enhance the image of the
business enterprise in public mind and are likely to improve its market standing.
Thus, in the long run profit ob$ectives and social ob$ectives do not conflict. Auch depends on top
management personal values, social concern and capability. Aanagement with high social sensitiveness
and strong feeling of personal obligation, considerable drive and skill can turn social ills into a business
opportunity.
E!OLUTION OF BUSINESS FINANE
To have a clear understanding of the role and responsibilities of finance manager, it would be worthwhile to
study changing contents of business finance as an academic discipline.
Before the turn of the present century finance was studied as a part of economics. #tudy of finance as a
separate discipline began only in the early part of the present century when massive consolidation
movement took place. %ormation of large sied undertakings by consolidating the smaller ones brought
before the management the problem of financing these gaint enterprises. )ccordingly, overwhelming
emphasis was placed to the study of sources and forms of financing the new industrial giants. )uthorities
on finance, like Aeade, Dewing and Byon dealt with, in a scholarly fashion, the problems of capitalisation,
choice of capital structure, promotions, sale of securities, nature and terms of financial contracts and
similar other matters related to source of raising of funds. Thus, the study of business finance remained
descriptive one.
7mphasis on study of potentially of different securities as a source of procuring funds from outside world
and the role and functions of institutional agencies including investment bankers continue to exist during
1101-s since this decade witnessed a burst of new industries, like radio, chemical, steel and automobile
upon the economic scene of the U#), the emergence of national advertising and improved distribution
practices and the euphoria of high profit margins.
1182-s was a period of grave economic recession which created formidable problem of li"uidity.
Businessmen found it difficult ot ac"uire funds from banks and other institutions to meet their day'to'day
re"uirements. They had to li"uidate their inventory holdings to meet their financial needs. But owing to
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precipitate fall in price level the inventory li"uidation did not provide sufficient funds to meet the
re"uirements. The impact of these developments upon financial management was manifested by improved
methods of planning and control, great concern for li"uidity and greater interest in sound financial structure
of the firm. .riters on business finance opined vehemently that finance manager would have to play
defensive role to protect the firm from dangers of bankruptcy and li"uidation. Thus, as in the past during
this decade too literature on business finance placed considerable emphasis on ma$or financial episodes in
the life cycle of he firm.
(roblem of financing assumed new dimension in the post world war ++, ,eorganiation of industries to cope
with the peace time re"uirements of the economy posed serious problem before the business community
to raise substantially large amount of capital form the market. )ccordingly, in =2-s financial experts
continued to be concerned with the necessity for selecting financial structures that would be able to
withstand the stresses and strains of he post war ad$ustments.
Thus, the approach to business finance, popularly known as traditional approach, which was evolved in the
beginning of the present century and which analysis the firm from an outsider-s points of view instead of
emphasiing the decision making aspects within the firm, remained popular until the early 32-s.
+n the early 32-s the U.#. economy witnessed vigorous spurt of the business activity on the one hand and
despondent stock market and tightening money market conditions, on the other. +n view of this, emphasis
shifted from profitability analysis to cash flow generation with a resultant deemphasis of the previously
favoured financial ratio analysis. The finance manager was assigned the responsibility of managing the
cash flows in such a manner that the organisation will have the means to carry out its ob$ectives as
satisfactory as possible and at the same time its obligations as they become due. There was thus observed
a market shift away from the institutional and external financing aspects to the primary emphasis on day'to'
day financial operations of the firm. 4ash budget techni"ue occupied a place of pride in writing on business
finance. Aatters like cash budget forecasting, aging receivables, analysis of purchases and application of
inventory controls received greater emphasis.
The change in approach to business finance noticed in the early 32-s was reaffirmed in the subse"uent
years. Bimited range of profit opportunities for mature industries and relatively tight money market
conditions which were the characteristic features of these years impelled the necessity for allocation of
capital resources to most profitable investment outlets. )ccordingly, capital budgeting as a tool of efficient
allocation of funds within the firm received dramatic premiums. The finance manager had to assume the
new responsibility of managing the total funds committed to total assets and allocating funds to individual
assets in consonance with the overall ob$ectives of the business enterprise.
4onse"uent upon a series of heated debates regarding cost of capital, optimal capital structure and effects
of capital structure upon the cost of capital and the market value of the firm that the profession went
through, a number of sophisticated valuation models were introduced and advanced techni"ues like
portfolio selection, mathematical programming and simulations were developed which improved the
practice of financial management.
The period between the mid 11C2-s and the early 11D2-s was marked as a very fruitful and exciting era for
a number of interesting developments. The brief but ominous recession in the share market spurred a large
number of diverstitures, reorganiations and bankruptcies and renewed concern for li"uidity and profit
margins. The analytical and empirical frontiers of the discipline were also at the same time redefined and
redesigned. The %inance manager started rethinking such important issues as aggregate stock prices, the
empirical efficiency of business sales, the profitability of institutional investors and the analytical efficiencies
of various portfolio selection criteria on a new line.
Thus, the dimension of business finance which was earlier limited to periodic or episodic financial events
BSPATIL D
has in recent years broadened to include the study of day'to'day operations of the financial management
alongside the periodic financial events. The case study is not being increasingly used as an aid in learning
how to analye and solve typical and recurring problems of financial management. The interest in case
study this stemmed from a desire for a more analytical approach.
MEANIN. OF BUSINESS FINANE
Biterally speaking, the term >business finance- contents finances of business activities. Thus, to develop the
meaning of business finance appreciation of the meaning of business and finance is necessary.
+n common paralance the word >Business- is used to denote merchandising, the operation of some sort of a
shop or store, a large or small. +t is, however, giving too narrow a meaning to the word. EBusiness must be
understood to embrace every human activity ;usually activated by the hope of profits, whereby man-s
wants are supplied. Bumbering, merchandising and many other activities are business that helps to supply
material wants. The practices of law, medicine, dentistry, teaching, accounting, nursing, entertaining
represents a few of the types of business activities that supply desired services.F Thus, business can be
categoried into three groups * 4ommerce, +ndustry and #ervice.
4ommerce is concerned with the transfer of commodities through numerous channels from the producer to
the ultimate consumers. +t includes collecting, grading, warehousing, transporting and insuring of
commodities. +ndustrial activity, on the other hand, is concerned with the sale of goods produced by
manufacturers. Thus, industrial businesses are those that actually produce commodities either by
manufacture or by some definite treatment of materials or that produce and supply the raw materials, which
may be used in their original form or form which marketable commodities can be manufactured. +n addition,
there are certain business activities that do not deal in tangible commodities, instead they render services
for making profit. #uch activates are classified under the category >#ervices-. ,ailroad and steam
companies, doctors, lawyers and bankers, brokers, accountants, teachers, actors, musicians and other
who do not deal with the commodities are the concrete example of services class of business activity.
!aving explained the meaning of business we now proceed finance ahead to define the term. %inance,
refers to the application of skills or care in the manipulation, use and control of money. This is as far as the
dictionary goes. +t would, however, not be in fitness of things to place too heavy reliance on the dictionary
meaning of finance because the word finance has a marvelous ability to evoke different concepts in the
minds of different persons. .e have, therefore, to turn from dictionary to observe what is being
contemplated in actual world about finance.
The word finance in real world has been interpreted differently by different authorities. Aore significantly,
as noticed in the preceding paragraphs, the concept of finance has changed markedly with change in times
and circumstances. %or the convenience of analysis, different viewpoints on finance have been categoried
into three ma$or groups.
;i< The first category incorporates the views of all those who contend that finance concerns with
ac"uiring funds on reasonable terms and conditions to pay bill promptly. This approach covers
study of financial institutions and instruments from which funds can be secured, the types and
duration of obligations to be issued, the timing of the borrowings or sales of stocks, the amounts
re"uired, urgency of the need and the cost. This approach has the virtue of shedding light on the
very heart of the finance function. !owever, the approach is too restrictive. +t lays stress on only
one aspect of finance and ignores the other aspect which is very vital.
;ii< The second approach holds that finance is concerned with cash. #ince almost all business
transactions are expressed ultimately in terms of cash, every activity within the firm is the concern
BSPATIL G
of the finance manager. Thus, according to this approach finance manager is re"uired to go into
details of every business activity be it concerned with purchasing, production, marketing, personnel
administration, research and other associated activities. &bviously, such a definition is too broad to
be meaningful.
;iii< ) less third approach to finance looks on finance as being concerned with ac"uisitions of funds and
wise application of these funds. (rotagonists of this approach opine that responsibility of a finance
manager is not only limited to procurement of ade"uate cash to meet business re"uirements but
extends beyond this to optimal utiliation of funds. #ince money involves cost, central task of the
finance manager, while allocating resources is to match the advantages of potential uses against
the costs of alternative sources so as to maximie the value of the firm. This is the managerial
approach which is also known as problem'centred approach, since it emphasies that the finance
manager is his endeavour to maximie the value of the firm has to deal with vital problems of the
firm vi., what capital expenditure should the firm make/ .hat volume of funds should the firm
invest/ !ow should the desired funds be financed/ !ow can the firm maximie its profitability from
existing and proposed commitments/
Diagrammatic of the management approach to finance give below will help appreciate the approach.
Fig/ 1/1/
MANA.EMENT APP#OA" TO FINANE
Acti)itie( &ore I0ea'
%unds #ources %unds Uses
+. +nternal 4ash %lows from operations
and special transactions.
+. )sset 7xpenditures
). 4urrent
B. %ixed
++. 7xternal Debts or e"uity funds
supplied by*
). +ndividuals
B. %inancial +nstitutions
4. &ther business firms
D. 6overnment
++. 5on'asset expenditure
). Babour
B. +nterest and debt service 4harges
+++. Distributions to owners and H or
losses
The management approach to finance is balanced one having given e"ual weightage to both procurement
and utiliation aspects of finance and hence has received wider recognition in the modern world.
Thus, business finance may be defined as the process of raising, providing and managing of all the money
to be used in connection with business activities. The similar view is also held by the modern scholars as
would be clear from perusal of some of the following definitions.
BSPATIL 1
EBusiness Finance can be broadly defined as the activity concerned with planning, raising, controlling and
administering of funds used in the business
.ut1mann 2 3ougall
EThe finance function is the process of acquiring and utilizing funds by a business.
#/ / O(4orn
Finance consists in the raising, providing, managing of all the money, capital, or funds of any ind to be
used in connection with the business.
Bonneville and Dewey
EBusiness Finance deals primarily with raising, administrating and disbursing funds by privately owned
business units operating in nonfinancial fields of industry.
Prat1er an0 -ert
NATU#E OF FINANE
%inancial management is an integral part of overall management and not a staff function. +t is not only
confirmed to fund raising operations but extends beyond it to cover utiliation of funds and monitoring its
uses. These functions influence the operations of other crucial functional areas of the firms such as
production, marketing and personnel. +n view of this, overall survival of the firm is influenced by its financial
operations.
The heart of the financial management lies in decision making in the areas of investment, finance and
dividend. +n investment decision a finance manager has to decide about total amount of assets to be held
in the enterprise and kinds of the assets ? the proportion of fixed assets and current assets. The basic
problems facing the finance manager concerning investments are*
;i< !ow should the firm invest/
;ii< +n which specific pro$ects should the firm invest/
+n financing decision the finance manager has to decide as to how much funds the firm should raise to fund
its operations and in what form'debt, e"uity shares, preferences shares and after sources. .hile deciding
about the debt'e"uity mix the finance manager-s endeavour should be to evolve such a pattern as may be
helpful in maximiing earnings per share and also market value of the firm.
The finance manager while making dividend decision decides as to how the firm-s should be allocated
between dividend and retention. !e has to formulate such a dividend policy as may provide sufficient funds
to finance the firm-s growth re"uirements and at the same time ensure reasonable dividends to the
stockholders.
The above decisions are intimately related. Thus, the proportion in which fixed assets and current assets
are mixed determines the risk complexion of the firm. 4osts of various methods of financing are affected by
this risk. Bikewise, dividend decisions influence financing decisions and themselves influenced by
investment decisions.
#ince finance functions are intimately connected with other business functions, the finance manager
should call upon the advise of other functional executives of the firm while making decisions particularly in
regard to investment. Decisions in regard to kinds of fixed assets to be ac"uired for the firm, level of
inventories to be kept in hand, type of customers to be granted credit facilities, terms of credit, etc., should
be made after consulting production and marketing executives. !owever, the determination of dividend
BSPATIL 12
policies is almost exclusive finance functions and the finance manager need not consult other functional
mangers.
%inally, imperativeness, of the continuous review of the financial decisions explains generic nature of the
financial management. )s a matter of fact, financial decision making is a c continuous dynamic process
that goes on throughout the corporate life. )n enterprise to survive has constantly to interact with various
environmental forces and adapt and ad$ust alive to changes in internal as well as external environment and
bring about necessary ad$ustments in goals, strategies, policies and procedures with a view to seiing
potential opportunities and minimiing impending threats. ) one time financial plan not sub$ected to
periodic review and modification in the light of changed conditions will be a fiasco because conditions
change to such as extent that the plan is no longer relevant and acts as a hindrance.
SOPE OF BUSINESS FINANE
+n order to understand more clearly the meaning of business finance it is worthwhile to highlight the scope
of business finance. )t the outset it may be pointed out that business finance is concerned with finances of
profit seeking organiations only and is important segment of private finance.
%inance, as such is but one facet of broader economic activity of mobiliing savings and directing them in
investments. %inance, includes both public and private finance. (ublich finance is the study of principles
and practices relating to ac"uisition of funds for meeting the re"uirements of government bodies and
administration of these funds by the government. 4ontrary to this, private finance concerns with procuring
money for private organisation and management of the money by individuals, voluntary association and
corporations. (rivate finance therefore comprises personal finance, business finance and the finance of
non'profit organiations. (ersonal finance seeks to analye the principles and practices of managing one-s
own daily affairs. #tudy of practices, procedures and problems concerning the financial management of
profit making organiations in the field of industry, trade and commerce and service and mining is
undertaken in business finance. The finance of non'profit organiation deals with the practices, procedures
and problems involved in the financial management of educational, charitable and religious and the like
organiations.
Business finance is further split into three categories ? finances of sole trading organisatoins, partnership
firms and corporate organiations. +n the study of business finance emphasis is given to financial problems
and practices of incorporated enterprises because business activities are predominantly carried on by
company form of organisation. That is why sub$ect of business finance is also studied as corporation
finance. +t should be remembered that the same principle of finance apply to large and small and
proprietary and non'proprietary organiations nevertheless there are sufficient differences of a specific
operating nature $ustifying separate consideration of each of these organiations.
The field of corporation finance encompasses the study of financial operations of a business enterprise
right from its very inception to its growth and expansion and in some cases to its winding up also. !owever,
special attention is devoted to the analysis of the problems and practices involved in raising and utiliation
of funds. +t should be noted that problems of purchase, production and marketing are outside the purview
of business finance although their problems are so intimately linked to problems of finance that in actual
practice it is difficult to discern them.
FINANE FUNTIONS
)s hinted in the preceding paragraphs, views of traditional and modern scholars regarding finance function
differ markedly. +t would, therefore, be germane to give a brief idea about their views.
BSPATIL 11
T#A3ITIONAL ONEPT OF FINANE FUNTION
Traditional writers contended that primary responsibility of a finance manager is to raise necessary funds to
meet operating re"uirements of the business. !e has to take decision with respect to the choice of
optimum source from which the funds would have to be secured, timing of the borrowing or sale of stock
and cost and other terms and conditions of ac"uiring these funds. (lanning "uantum and pattern of fund
re"uirements and allocation of funds as among different assets, sais traditional scholars, is the concern of
non'financial executives.
Traditional approach to finance function has been bitterly criticied by modern scholars on various cogent
grounds. &ne such ground is that the traditional approach is too narrow. +t viewed finance as a staff
specially. )ccording to them, it would be mistaken to argue that responsibility of the financial executive is
limited to ac"uisition of sufficient funds for the enterprise and he has little concern as to how such funds
would be allocated.
)nother criticism of traditional approach is that it over emphasied episodic and non'recurring problems
like, incorporation, consolidation, reorganiation, recapitaliation and li"uidation and gave little attention to
day'to'day financial problems of on going concerns.
)nother shortcoming of the traditional approach is that it gave concentrated attention to problems of
corporation finance while problems of unincorporated organiations like sole trading concerns and
partnership firms were altogether ignored.
%inally, modern authorities charged that the traditional approach laid relatively more stress on problems of
long'term financing as if business enterprises do not have to encounter any financial trouble in the short
run. )s a matter of fact, problem of working capital management is very crucial problem which has to be
dealt with efficiently by the finance manager if an enterprise has to reach the goal of wealth maximiation.
MO3E#N ONEPT OF FINANE FUNTION
Aodern #cholars viewed finance as an integral part of the over'all management rather than as a staff
speciality concerned with fund raising operations. )ccordingly, finance manager has been assigned wider
responsibilities. )ccording to them, it is not sufficient for the finance manager to see that firm has sufficient
funds to carry out its plans but at the same time he has to ensure wide application of funds in the
productive process. Thus, to carry out his responsibilities it is the bounden responsibility of the finance
executive to make a rational matching of the benefits of potential uses against tht costs of alternative
potential sources so as to help the management to accomplish its broad goal. The finance manager is,
therefore, concerned with all financial activities of planning, raising, allocating, and controlling and not with
$ust any one of them. )side from this, he has to handle such financial problems as are encountered by a
firm at the time of incorporation, li"uidation, consolidation, reorganiation and the like situations that occur
infre"uently.
Thus, finance functions, according to modern experts, can be categoried into two broad group E ,ecurring
finance function and 5on'recurring finance function. .e shall now discuss in detail each of these functions
separately.
A/ #EU##IN. FINANE FUNTION
,ecurring finance function encompasses all such financial activities as are carried out regularly for the
efficient conduct of firm. (lanning for an raising of funds, allocating of funds and income and controlling the
uses of funds are contents of recurring finance functions. .e shall now discuss in brief, each of these
functions.
BSPATIL 10
&1' Planning For Fun0(
+nitial task of the finance manger is a new or going concern is to formulate financial plan for the form.
%inancial plan is the act of deciding in advance the "uantum of funds re"uirements and its duration and the
makeup of the re"uirements to achieve the primary goal of the enterprise. .hile planning for fund
re"uirements the finance manager has to aim at synchroniing the cash inflows with cash outflows so that
the firm does not have any resources lying unutilied. #ince in actual practice with a synchroniation is not
possible, the finance manager must maintain some amount of working capital in reserve so as to ensure
solvency of the firm. The magnitude of this reserve is the function of the amount of risk that the firm can
safely assumes in a given economic and business conditions.
:eeping in view the ling'term goals of the company the finance manager has to determine the total fund
re"uirements, duration of such re"uirements and the forms in which the re"uired funds will be obtained.
Decision with respect to fund re"uirements is reflected in capitalisation. .hile determining fund
re"uirements for the enterprise, the finance manger must keep in mind the various considerations, vi.,
purpose of the business, economic and business conditions, management attitude towards risks,
magnitude of future investment programmes, state regulation, etc.
Broadly speaking, there are two methods of estimating funds re"uirements* Balance sheet method and
4ash budget method. +n balance sheet method total capital re"uirements are determined by totaling the
estimated amount of current, fixed and intangible assets re"uirements. +n contrast, a forecast of cash
inflows and cash outflows in made month'wise and cash deficiencies are calculated to find out the financial
needs under the cash budget method. .ith the help of cash budget amount of fund re"uirements at
different time intervals can be calculated.
!aving estimated total funds re"uirements the financial executive decides as to how these re"uirements
will be met, vi., forms of financing funds re"uirements. #uch decisions are taken under capital structure.
.hile there may be various pattern of capital structure, the finance manager should decide upon the most
suitable pattern of capital structure for the enterprise.
+n order to enable the finance department to perform the aforesaid functions effectively and to achieve the
firm-s ob$ectives successfully, finance manager must establish suitable policies that act as guides to the
executives of the finance department. Aa$or policy guidelines in this respect are*
a< (olicies regarding "uantum of funds re"uirements of the firm.
b< (olicies regarding debt ? e"uity mix.
c< (olicies regarding choice of funds
These policies must be reviewed from time to time keeping in view the changing needs of the firm and
environmental changes.
&*' #ai(ing of Fun0(
The second responsibility of the finance manager is procuring the re"uisite capital to satisfy the business
re"uirements. +f the company decides to raise the needed funds by means of security issues, the financial
manger has to arrange the issue of prospectus for the flotation of issue. +n order to ensure "uick sale of
securities generally the stock brokers, who deal in securities in the stock market and who are in constant
touch with their clients, are approached.
7ven after the issues are floated in the stock market there is no certainty that the security issues will bring
in the desired amount of capital because public response to security is difficult to estimate. +f a business
enterprise, fails to assemble the desired amount of funds through security issues, the enterprise is plunged
into grave financial trouble. #o as to hamstring this problem the finance manager has to make such
BSPATIL 18
arrangements as may protect the issue against its failure. %or that matter, he has to approach underwriting
firms whose main $ob is to provide the guarantee of buying the shares placed before the public in the event
of non'subscription of the shares. %or these services, they charge underwriting commission. Thus, if an
underwriter is satisfied with the issuing company, an underwriting agreement is entered into between the
company and the issuing company. The obligation of the underwriter as per the agreement arises only
when the event of non'subscription of issues by the public takes places.
.here the company decides to borrow money from financial institutions including commercial banks and
special financial corporations, the finance manger has to negotiate with the authorities. !e has to prepare
the pro$ect for which the loan is sought and discuss it with the executives of the financial institutions along
with the prospects of repayment of the loan. +f the institution is satisfied with the desirability of the proposal,
an agreement is entered into by the finance executive on behalf of the company.
&+' Allocation of Fun0(
The third ma$or responsibility of the finance manager is to allocate funds among different assets. +n
allocating the funds, consideration must be given to the factors such as competing uses, immediate
re"uirements, and management of assets, profit prospects and overall management plans. !owever, he
has to ac"uaint the production executive who is primarily seied with the task of ac"uiring fixed assets with
fundamentals of capital expenditure pro$ects and also about the availability of capital in the firm. But the
efficient administration of financial aspects of cash, receivables and inventories is the prime responsibility
of the finance managers.
The finance executive has also to see that only that much of assets are ac"uired that could meet the
current as well as the increased demand of the company-s product. But the efficient administration of
financial aspects of cash, receivables and inventories is the prime responsibility of the finance manager.
The finance executive has also to see that only that much of fixed assets are ac"uired that could meet the
current as well as the increased demand of the company-s product. But at the same time he should take
steps to minimie the level of buffer stock of fixed assets that the company is re"uired to carry for the
whole year to satisfy the expanded demands. .hile managing cash, the finance manger should prudently
strike a golden mean between these two conflicting goals to profitability and li"uidity of the corporation. !e
has to set minimum level of cash so that the company-s li"uidity is not $eopardied and at the same time its
profitability is maximied. Besides, the finance manager has to ensure proper utiliation of cash funds by
taking steps which help in speeding up the cash inflows on the some hand and showing cash outflows, on
the other.
+n managing receivables the finance manager should endeavour to minimie the level of receivables
without adversely affecting sales. %or that matter, suitable credit policies should be laid down and suitable
collection procedures should be designed.
The operating responsibility of managing inventories in a corporation is outside the province of the finance
manger and well within the realm of production manager and chief purchase officer. !owever, the financial
manger is responsible for supplying the necessary funds to support the company-s investments in
inventories. +n order to ensure that funds are allocated efficiently in inventories, the finance manager must
familiarie himself with various techni"ues by which efficient management of inventories can be achieved.
The problem that the finance manager faces is to determine the optimal magnitude of investment in
inventories. .ith the help of the 7.&.I. ;7conomic &rder Iuantity< model suitable level of inventories is
decided.
BSPATIL 1=
&5' Allocation of Income
)llocation of annual earnings of the company as between different uses is the exclusive responsibility of
the finance manger. +ncome may be retained for financing expansion of business or it may be distributed to
the owners as dividend as a return of capital. decision in this respect is taken in the light of financial
position of the company, present and future cash re"uirements of the firm, shareholders, preferences and
the like.
&6' ontrol of Fun0(
) finance manger is also responsible for controlling the uses of funds committed in the enterprise. This will
enable him to ensure that fund are being utilied as per the plan. 4ontrol function involves development of
standards. 7stablishing standards is an essential task of the finance manger which re"uires high degree of
dexterity and skill and the use of sophisticated forecasting techni"ues. These standards serve as a
concrete basis for evaluation of current performance. 4omparison of actual with predetermined standards
provides opportunity to the management to ascertain immediately the discrepancies that have occurred
and take remedial steps before deviations go out of control. +f the assessment of the performance reveals
that the actual operations have not conformed to the standards, the reason for this discrepancy may be
traced either in the inade"uacy of the firm-s policies or ineffectiveness of the employees. if the policies are
found to be effective, the finance manager must identify those policies that have not been effective and
suitable and them change such policies so that the firm can accomplish its ob$ectives.
7valuation work should be performed continuously in view of constantly changing environmental forces.
.henever and wherever necessary policies should be changed.
B/ NON7#EU##IN. FINANE FUNTION
5on'recurring finance function refers to those financial activities that a financial executive has to perform
very infre"uently. (reparation of financial plan at the time of promotion of the enterprise, financial
read$ustment in times of li"uidity crises, valuation of the firm at the time of merger reorganiation of the
form and similar other activities are of episodic character. #uccessful handing of such problems re"uires
financial skills and understanding of principles and techni"ues of finance peculiar to non'recurring
situations.
O#.ANI%ATIONAL F#AME-O#8 FO# FINANIAL MANA.EMENT
%unctions of financial management stated above are, by and large, the same in almost all types of
business concerns. !owever, organisatoin of these functions is not standardied one. +t varies from
enterprise to enterprise depending essentially on the characteristics of firm, sie, nature convention, etc.
Thus, in similar companies where operations are relatively simple and less complicated and little
delegation of management functions exists, no separate executive is appointed to handle finance
functions. +n fact, it is the proprietor who handles all these activities himself. !e prepares cash budget for
his firm to assess the re"uirements and arranges finance to meet these re"uirements. !e himself looks
after receivables and disbursement work, extends credit, collects accounts receivables, manages cash
accounts and arranges additional funds, in collects accounts receivables, managers cash accounts and
arranges additional funds, in such concerns, finance function is not properly defined and finance function is
combined with production and marketing functions. %inancial planning is hardly given important place.
(roprietors have seldom any training in such activities.
BSPATIL 13
.ith growth in the sie of the organisation degrees of specialiation of finance function increases. +n
medium sied undertakings financial activities are handled by senior management executive who is
designated as treasurer, finance director, finance controller, vice'president in charge of finance. !e is
generally given the charge of credit and collection departments and accounting department, investment
department and auditing department. !e is also responsible for preparing annual financial reports. !e
reports directly to the president and board of directors. !is vice in decision making depends in part on his
ability and whether or not his firm is one that is closely held.
+n large concerns the finance manager is a top management executive who participates in various decision
making functions, for example, those involving dividend policy, the ac"uisition of other firms, the
refinancing of maturing debt, introducing a ma$or new product, discarding an old one, adding a plant or
changing locations, floating a bond or a stock issue, entering into sale and lease back arrangements. +n
most of the cases the finance manger holds the rank of vice'presidentship reporting directly to the
president and Board of Directors. (lace of finance in management hierarchy in large enterprise has been
diagrammatically portrayed in figure 1.0. +t appears that a large organisation has finance committee
consisting of some members of Board and a finance manager. The committee makes recommendations for
the final approved of the Board.
Figure 1/*
+n larger concerns, for handling financial matters controller and Treasurer are appointed. %inance controller
is responsible for financial planning and control, preparation of annual financial reports and for carrying on
capital expenditure activities whereas treasure-s responsibility is limited to raising additional resources for
business purposes, management of working capital and security investment and tax and insurance affairs.
BSPATIL 1C
#OLE OF FINANE MANA.E# IN AN ENTE#P#ISE
%inance manager is an integral part of corporate management of an enterprise and is involved in almost all
the crucial decision making affairs because every problem and every decision entails financial implications.
%inance manager plays significant role in helping the business entrepreneurs and management in
overcoming their business problems and accomplishing their wealth maximiation ob$ective. &ne of the
prime problems facing 4orporate management is in the area of capital investments. !ow much capital
expenditures should the enterprise commit, what volume of funds should be committed and how should
funds be allocated as among different investment outlets are the critical issues which have to be handled
with utmost care failing which the enterprise may land in grave financial crises. The finance manager with
his expertise knowledge management in choosing the most viable pro$ect promising maximum results
coupled with minimum risks.
The 4entral management also faces formidable problem of allocation of funds and they have to strike trade
off between two conflicting but e"ually important goals of the business i.e. profits vs wealth maximiation
!igher the relative share of li"uid assets, lesser will be the possibility of cash drain, other things being
e"ual. !owever profitability in the case will be less. &n the contrary, if a smaller share of funds is held in
li"uid form, risk of insolvency will be high but profitability will also be higher. The management is, thus, in
dilemma which the finance manager endeavors to resolve by making use of principles and techni"ues of
finance.
)nother problem plaguing the managemnet pertains to designing such pattern of capitalisation as may be
helpful in maximiing earnings per share and so also the market value of shares. This involves examination
in depth of some of the important issues such as form what sources are funds available, to what extent are
funds available from what sources, what is expected cost of future financing, what sources of funds should
be tapped and to what extent, what financial instruments should be employed to raise funds and at what
time/, which financial institutions should be approached for garnering funds/ The finance manager with his
knowledge of finance, capital and Aoney markets, investors psychology, etc. offers solutions to these
problems.
&nce the business is set up and earns profit, the corporate management has to decide about allocation of
earnings between payments to shareholders and rationed earnings. !ere again the management is in
dilemma a trade off between growth and dividends, the two e"ually desirable but conflicting goals of the
enterprise. ) satisfactory compromise between the two has to be struck in such a way that shareholder-s
wealth in the enterprise is maximied. The central management calls upon the expertise of the finance
manager in striking such compromise and helps the management in prudent allocations of income.
Besides handling day ? to ? day problems, finance manger also helps the corporate management in
dealing with episodic problems including reorganiation, merger, consolidation and li"uidation.
Thus, finance manger plays a very significant role in optimal utiliation of financial resources in the firm and
thereby ensures the successful survival and growth of the latter.
3EFINITION OF FINANE FUNTION
). Task of (roviding %unds ? )ccording to these following definitions, the finance function is simply
the task of providing funds needed by the enterprises on suitable terms.
1. E+n a modern money ? using economy, finance may be defined as the provision of money at the
time it is wantedF.
' F/-/ Pai(1
BSPATIL 1D
0. E+n an organism composed of a myriad of separate enterprises, each working for its own ends
but simultaneously making a contribution to the system as a whole, some force is necessary to
bring about direction and co'ordination. #omething must direct the flow of economic actively
and facilitate its smooth operation. %inance is the agent that produces this resultF
? "u(4an0 an0 3oc,er9
8. EThe financing function includes the day'to'day concern for the use and control of funds as well
as long range planning which is involved with determining future re"uirements for funds and
optimum uses to which they mat be put. The financial policies of the firm are exemplified in its
basic decisions about methods of financing growth, dividend distribution policy, relations with
lending institutions, economic evaluation of alternative investments in plant and e"uipment and
other activities which involves uses or sources of fundsF.
' L/A/ an0 /E/ .u4ellini
=. EBusiness finance may be broadly defined as the activity concerned with planning, raising,
controlling and administering of funds used in the businessF.
' "/ .ut1man an0 "/ 3ouggal
)bove mentioned definitions of finance highlight the central core of finance function, i.e., procurement of
funds for the business, but to confine it to this aspect only is a narrow view. +t is broader function than that
of funds supply only. +t includes the financing decisions, investment decisions as well as dividend
decisions. %inancial management is deeply concerned with the economic and effective use of funds.
Therefore, this view cannot be accepted.
B. Aanagement of cash and li"uidity ? )ccording to the following definition finance function is the
management of cash and maintaining the li"uidity of funds.
EThe term finance can be defined as the management of the flows of money through an
organiation, whether it will be a corporation, school, bank or government agencyF. John J.
!ampton. The task of working capital management is not over'all responsibility of financial
management. +t is also a narrow concept ant the functions of a financial executive extend to
financial planning, funds raising and administration of funds, etc. +f we entrust the financial function
completely to the accountant, it will be a very limited view of finance function. +t may be summed up
as the >custodian function of finance- in the sense that it involves only the proper custody and
authoried utiliation of the available funds.
4. %inancial decision making ? %ollowing definitions are concerned with the financial decision ?
making.
1. E%inance may be defined as the administrative area or set of administrative functions in an
organisation which relate with the arrangement of cash and credit so that the organiation may
have the means to carry out its ob$ectives as satisfactorily as possibleF.
' "o:ar0 an0 Upton
0. EThe %inance function is vitally concerned with the use of funds within the business not $ust the
supply of funds to the businessF.
' "unt; -illiam an0 3onal0(on
BSPATIL 1G
+n this way finance function covers not only financial planning, financial forecasting, finance raising bout
optimum use of funds as well as the financial control
#OLE AN3 SOPE OF FINANIAL FUNTION
%inancial function seeks to carry out production and marketing functions profitably. These need funds for
investment in fixed assets and current assets. %ollowing are the main financial functions.
MAIN FINANE FUNTIONS
1. To e(timate t1e #e<uirement( of Fun0( ? Bong ? term as well as #hort'term'funds re"uirement,
the investments in fixed assets and those in various current assets etc. should be estimated
through the techni"ues of budgetary control and long'range planning. This re"uires proper forecast
of the physical activities of the organiation.
0. To ta,e Finance 3eci(ion( or apital Structure 3eci(ion( ? 7ach source of funds involves
different considerations regarding cost, risk and control. :eeping these in mind, a proper mix of the
various sources has to be worked out. Bong'term funds investments are to provide for the needs of
the core working capital. funds should be procured at optimum costs with the least risk and the
least dilution of control of the present owners. These decisions come under the broad term >the
financing decision-.
8. To ta,e In)e(tment 3eci(ion Bong'term funds should be invested in various pro$ects only after
an in depth analysis has been carried out through capital budgeting techni"ues and uncertainly
analysis. )sset management policies are to be laid down regarding various items of current assets
also. These include policies relating to management of inventories, book debts, cash, trade
creditors etc.
=. To ta,e 3i)i0en0 3eci(ion %rom the economic point of view, the amount to be retained or to be
paid to the shareholders would depend on whether the company or the shareholders can make a
more profitable use of the funds. +n practice, a large number of other considerations like the trend of
earnings, the trend of share market prices, the re"uirement of funds for future growth, the cash flow
situation, restrictions under the 4ompanies )ct., the tax position of the shareholders etc. are also
kept in mind.
SUBSI3IA#= FINANE FUNTIONS
1. #upply of funds to all parts of the organiation
0. 7valuation of financial performance
8. %inancial negotiations with bankers, financial institutions and other suppliers of credit.
=. :eeping track of stock exchange, "uotation and behaviour of stock market prices.
3. %inancial 4ontrol
C. :eeping the records of all assets.
BSPATIL 11
3EFINITION OF FINANIAL MANA.EMENT
1. E+t the application of general managerial principles to the area of financial decision makingF.
' "o:ar0 an0 Upton
0. E%inancial Aanagement is an area of financial decision making, harmoniing individual motives and
enterprise goalsF.
' -e(ton an0 Brig1am
8. E%inancial Aanagement is the operational activity of a business that is responsible for obtaining and
effectively utiliing the funds necessary for efficient operationsF.
' Jo(ep1 an0 Ma((ie
=. E+n an organism composed of a number of separate activities, each working for its own end out
simultaneously making a contribution to the system as a whole, some force is necessary to bring
about direction and coordination of economic activity and facilitate its smooth operation. %inancial
management is the agent that produces this resultF.
' "u(4an0 an0 3oc,er
3. E%inancial management is concerned with the managerial decisions that result in the ac"uisition
and financing of long'term and short'term credits for the firm. )s such it deals with the situations
that re"uire selection of specific assets ;or combination of assets<, the selection of specific liability
;or combination of liability< as well the problems of sie and growth of an enterprise. The analysis of
these decisions is based on the expected inflows and outflows of funds and their effects upon
managerial ob$ectivesF.
' P1ilippatu(
C. E%inancial Aanagement is the area of business management devoted to a $udicious use of capital
and a careful selection of sources of capital in order to enable a business firm to more in the
direction of reaching its goalsF.
' J/F/ Bra0le9
"A#ATE#ISTIS OF FINANIAL MANA.EMENT
1. In)e(tment 0eci(ion( These include decisions as regards utiliation of funds in one activity or
the other.
0. Financing 0eci(ion( These include decisions as regards how the total funds re"uired by the firm
are to be raised, namely, by issue of shares, by raising of loans, or by retaining of profits.
8. 3i)i0en0 0eci(ion( These include decisions as regards what part of the profits earned by the
BSPATIL 02
firm is to be distributed among the shareholders in the form of cash dividend, and how much of the
profit are to be retained for utiliation by the firm ;ploughing back<, and
=. Enforcing Financial 0eci(ion This is done through control and coordination of business
activities.
Thus financial management is an operational function in involving financial planning, financial forecasting
and provision of financial as well as the formulation of financial policies. !unt, .illiam and Donaldson have
called it >,esource Aanagement-. +n a large organiation, the financial manager is the member of the firm-s
top management charged with the responsibility of planning, organiing, performing and controlling the
financial affairs of the enterprise.
FUNTIONS OF FINANIAL MANA.EMENT
The finance functions include 7xecutive or Aanagerial %unctions as ,outine %unctions. .hile 7xecutive
functions re"uire skilled planning and execution of financial activities, routine finance functions are chiefly
clerical and are identical to the effective handling of the managerial functions.
1/ E>ecuti)e or Managerial Function(
;i< %inancial forecasting* The financial management arranges that an ade"uate supply of cash
in available at the proper time for smooth flow of firm-s activities. )s cash'inflow and cash
outflow both are closely related to the volume of sales, it re"uires financial forecasting. The
estimation of the prospective inflow and outflow of cash in the next "uarter or year is
necessary to maintain the li"uidity in the funds.
;ii< +nvestment Decisions ? This is the most important executive function of financial executive.
+t involves the allocation of capital to various investment proposals in order of their
profitability. The financial manager has little or not operating responsibility for fixed assets,
because these decisions are made by top management. !e is however instrumental in
allocating capital to these assets due to his involvement in capital budgeting. )s each
investment decision involves risk, a financial manager assets in evaluating the various
proposals in the processes of capital budgeting.
;iii< Aanagement of 4orporate )sset #tructure ? The fixed and current assets of the firm must
be managed efficiently to ensure success. The financial manager is charged with varying
degrees of operating responsibility over existing assets. !e is rather concerned with the
management of current assets than with fixed assets. +n the management of current assets
his discretion is not an exclusive one. &ther area manages also participate in the formation
of policies regarding the level of investment in various current assets like inventories etc.
;iv< Aanagement of +ncome ? +t is a ma$or function of financial executive. +t includes the
allocation of net earnings after payment of taxes among shareholders and rationed earning
for employees. the shareholders are generally more interested in current cash dividends. +n
order to provide for future contingencies, the top management wants to retain earnings to
the maximum possible extent. The financial manager attempts to arrive at an optimal
dividend ? pay out ratio that maximie shareholder-s worth in the long run.
;v< Aanagement of 4ash ? The cash must be managed for the benefit of the owners. The
BSPATIL 01
financial manager has two ob$ectives ;a< how can managers choose the best among the
alternative uses of funds, and ;b< how can they ascertain that this is a better use than stock'
holders could find outside the company/ ETherefore, the financial manager must select the
most desirable temporary investment for the excess cash and near cash resources of the
firm.
;vi< Decision about 5ew #ources of %inance ? ) business firm is always in need of funds. &n
the basis of forecast of the volume of operations the financial manager should decide upon
the needs and prepare the detailed financial plan both short'term and long'term for the
procurement of funds. !e should evaluate the prospective cost of funds as against the
anticipated profits from the use of these funds by the operating units to which they are to be
allocated.
;vii< 4ontact and carry 5egotiations for 5ew %inancing ? The %inancial manger has to contract
the source, carry on the negotiations and finalie the terms and conditions of the contract. +n
short term, credit is arranged from a bank, lines of credit are to be opened and financial
executive negotiates with bank authorities in this connection. +f long'term funds are needed
additional shares should be issued for it. This re"uires a number of arrangements to be
made by him.
;viii< )nalysis and )ppraisal %inancial (erformance ? (roper analysis, checking and appraisal of
financial performance is essential to carry out finance function smoothly. Karious financial
statements are prepared analyed and then necessary guide'lines are set for future.
)nalysis of what has happened is of great value in improving the standards, techni"ues and
procedure of financial control.
;ix< To )dvise the Top Aanagement ? The financial manager advises the top management in
respect of financial matters and suggests various alternative solutions for any financial
difficulty. !e makes steady efforts to increase the profitability of capital invested in the firm.
*/ Inci0ental or #outine Function(
%ollowing are routine functions performed by low level assistants like accountants, assistants, accounts
assistants, etc.
1. ,ecord keeping and reporting
0. (reparation of various financial statements
8. 4ash management
=. 4redit management
3. 4ustody and safeguarding the different financial securities etc.
C. (roviding top management with information on current and prospective financial conditions of the
business as a basis for policy decision on purchases, marketing and pricing.
IMPO#TANE OF FINANIAL MANA.EMENT
1. Succe((ful Bu(ine(( Promotion Defective financial plan is one of the most important reasons
of failures of business promotion. +t the plan fails to provide sufficient capital to meet the
re"uirements of fixed and fluctuating capital and to assume the obligations by the corporation, the
business cannot be carried on successfully. !ence sound financial plan is very necessary for the
BSPATIL 00
success of business enterprise. +n the words of !oagland, EUnwarranted optimism and lack of
information are more often the cause of faulty financial plans, optimism about the possibilities of an
untried enterprise, and lack of information about the specific needs and limitationsF. #election of
sound financial plan re"uires a serious consideration over factors like profitability, risk and controls
of various alternative plans. This is not possible in the absence of a sound financial management.
0. Smoot1 #unning of Enterpri(e #ound financial planning is necessary for the smooth running of
an enterprise. )s finance is re"uired in promotions, incorporation, development, expansion and
administration of day'to'day working etc. its proper administration is very necessary. This means
the study, analysis and evaluation of all financial problems to be faced by the management and to
take proper decision with reference to these present circumstances in regard to the procurement
and utiliation of funds.
8. oor0ination of Functional Function( %inancial administration provides co'ordination between
various functional areas such as marketing, production etc. +f financial management is defective,
the efficiency of all other departments cannot be maintained. +f finance department fails in its
obligations, the production and the sales will suffer. 4onse"uently, the income of the concern and
the rate of profit on investment will also suffer. Thus, financial administration controls and co'
ordinates all other activities in the concern.
=. "elp in 3eci(ion Ma,ing 7very decision in business is taken in the light of its profitability.
)mong a number of alternatives to carryout the decision the management has to select only the
best in terms of its profitability. %inancial administration provides scientific analysis of facts and
figures through various financial tools, such as different financial statements, budgets ratio analysis,
cost'profit'volume analysis etc. These help in evaluating the profitability of the plan in the given
circumstances, so that a proper decision may be taken to minimie the risk involved in the plan.
3. 3etermination of Bu(ine(( Succe(( The financial managers plan a very important role in the
success of the business organiation by advising the top management and presenting important
facts and figures regarding financial position and the performance of various functions of the
company in a given period before the top management in such a way so as to make it easier for the
top management to evaluate the progress of the company and to amend suitably the principles and
policies of the company. By suggesting the best possible alternative out of the various alternatives
of the problem available, the financial managers assist the top management in its decisions making
process.
C. Mea(ure of Performance )s J.%. .eston and 7.%. Brigham have said, E%inancial decisions
affect both the sie of earnings stream or profitability and the riskiness of the firm. (olicy decision
affect risk and profitability and there two factors $ointly determine the value of the firmF.
BSPATIL 08
UNIT II
O#.ANI%ATION OF FINANIAL MANA.EMENT
&rganisation of financial department is the division and the classification of various functions which are to
be performed by the finance department. %inance is one of the important functions of the management.
%inancial decisions affect wage policy, inventory policy, labour policy and every other area of decision
making and the reverse is also true. Aanagement decisions are made at every level of business
organisation from president to foreman and nearly management decision involved the finance of the
company.
)s finance affects the very existence of a concern, the finance function cannot be decentralied like other
management functions such as personnel, marketing etc. The control and administration of finance should
be given to the top management. 4ontrolling and administrative powers may vest in the Board of Directors
or in the %inance 4ommittee.
The place of finance department in the organiation chart depends on the sie and the nature of the
business. +n a very small business having one man as the proprietor he may make all the management
decision including financial policies. !owever, in large businesses, a division of responsibility and the
compartmentaliation of management are necessary to handle the large volume of work. )s finance is one
of the most important functions of management re"uiring skill and technical expertise, a separate
department for the purpose is established under the charge of an expert in financial matters known as
%inance Aanager or %inance 4ontroller or Director of %inance. The 4hart 5o. 0.1 shows an ideal form of
organiation for a big business corporation.
FINANE OMMITTEE
The shareholders, the owners of the corporation control the conduct of the company by electing the Board
of Directors, to whom the management is responsible. 4ompany policies are executed with the help of the
managing director who manages the affairs of the company as per directions of the board. )s the
managing director is not an expert of all the matter'labour, market, finance, production etc. relating to the
business, a committee for each function'repairing expert knowledge is constituted for proper guidance and
advice. Thus a finance committee may be constituted to advise the managing director regarding matters
relating to finance of the concern. This may include one or tow directors from the board of directors, the
departmental heads and the chief financial mangers with managing director as the chairman of the
committee. The committee guides and advises the board of directors the control and administration of the
finance.
BSPATIL 0=
STATUS OF FINANE MAN.E#
The finance manger is located on the same scalar level as the managers of production department or
marketing department etc. !e is full'fledged head of finance department and reports directly to the chief
Directors. !e is appointed to look after the activities of the finance department. The controller of finance
and the treasurer are the two officers subordinate to the financial manager. The treasurer-s responsibility is
to look after the day to day working such as custody of cash and bank accounts, investment portfolio of the
corporation, collection of loans, payments of premiums etc. 4ash receipts and disbursements include such
names as )ccounts ,eceivable, )ccounts (ayable, 6eneral Bedger, +nternal )udit, (ay'roll, Tax, 4redits
and 4ollections, budget etc. To prevent unauthoried payments made by the treasurer, it must be
approved by the controller. 4ontroller is responsible to the finance committee.
) detailed organisation for finance department can be drawn it the enterprise is to be managed by one
financial officer*
BSPATIL 03
%ig. 0.0 &rganisation of %inance Department
)s there is a very wide range of organiational practices the organiation structure may change according
to the sie and nature of the business. +t is also effected by the external factors such as state intervention
in the industrial finance, corporate tax policies etc. %ig. 0.0 shows organiation of finance department.
FUNTIONS OF FINANIAL MANA.EMENT
The three important activities of a business firm are finance, production and marketing. Through finance
activity the firm secures capital which sis employed through production and marketing activities. This a
business firm engages in activities to perform the functions of finance, production and marketing. +t
ac"uires funds from the sources called investors. .hen invested, funds are called investments. The firm
expects to receive returns on investments over time. +t periodically distributed returns to investors. These
processes are simultaneous and continuous. These are called the finance functions of the firm. These are
as follows*
1/ To #ai(e Fun0( %unds are two types* e"uity funds and borrowed funds
;i< E<uit9 Fun0( ) firms sells shares to ac"uire e"uity funds. These represent ownership
rights of shareholders. They invest their money in the shares of a company in the
BSPATIL 0C
expectation of returns on their invested capital in the form of dividend. #hares may be of two
types * common and preference. (reference shareholders receive dividends at a fixed rate
and have a priority over common shareholders in receiving dividends. The dividends rate for
common shareholders is not fixed. +t varies from year to year depending on the decision of
the board of directors. The payment of dividends to shareholders is an absolute discretion of
the board of directors.
;ii< Borro:e0 Fun0( )n important source of securing capital is creditors or lenders who are
not owners of the company. They supply money to the firm on leading basis and retain title
to the funds lent. Boans are furnished for a specific period at a fixed rate of interest. The
return on loans or borrowed funds is called interest. (ayment of interest is a legal obligation
of the firm. 4reditors includes banks, financial institutions, debenture holders and others.
*/ To #etain Earning( .hen company secures funds by retaining a portion of the returns available
for shareholders, this method of ac"uiring funds is called retaining earnings. )s the retained
earnings are undistributed returns on e"uity capital, they are a part of e"uity capital. The retention
of earnings can be considered as a form or raising new capital. +f a company distributes all earnings
to shareholders, then, it can re"uire new capital from the same sources by issuing new shares.
+/ To plan in)e(tment pro?ect The funds raised by a company are invested in the available
investment opportunities called investment pro$ect or pro$ect. These involve use of funds in the
expectation of future benefits. The company may also have on'going pro$ects which involve outlays
of cash to maintain or to increase their profitabilities. 6eneration of revenue is possible only when
funds are invested in pro$ects.
5/ To carr9out all t1e 4u(ine(( acti)itie( There is an inseparable relationship between the finance
function and the production, marketing and all kinds of business activities. Directly or indirectly
these involve e the ac"uisition and use of money. !owever, it need not necessarily limit or
constraint the general running of the business. ) company in a tight financial position will give more
weight to financial considerations.
T"E #OLE OF FINANIAL MANA.E#
T#A3ITIONAL APP#OA"
Traditional the scope of financial management and the role of the financial manger were considered
confined to the raising of funds. !e was called upon to raise funds during the ma$or events, such as
promotion, reorganiation, expansion etc. !is only significant duty was to see that the firm has enough
cash to meet its obligations. Till the mid ? 1132-s the finance books covered discussion of the instruments,
institutions and practices through which funds are obtained. These books contained detailed descriptions
of the ma$or events like mergers, consolidations, reorganiations, recapitaliations etc. The traditional view
on financial management was based on the assumption that the financial manager has not concern with
the decisions of allocating firm-s funds, he is only re"uired to raise the needed funds from the combination
of various resources.
The basic contents of the traditional approach, which also form its limitations, may be summaried as
follows. )ccording to (rof. #olomon.*
1. To #ai(e Fun0( The emphasis in the traditional approach was on raising of funds. The sub$ect of
BSPATIL 0D
finance was treated from the investors- point of view. The point of view of the financial decision ?
maker was given no importance. The traditional view, thus, was the outsider ? looking ? in
approach.
0. Epi(o0ic Function The traditional approach was circumscribed to the episodic financing
function. +t placed overemphasis on topics of securities and its markets, promotion, incorporation,
merger etc.
8. Solution of Long7Term pro4lem( The traditional approach placed great emphasis on the long'
term problems. +t ignored the importance of the working capital management.
=. Pro4lem of Non7corporate enterpri(e( The traditional approach used to give significant
attention to the financing problems of noncorporate enterprises.
#ITIISM OF T#A3ITIONAL !IE-
1. Lac, of information of control( an0 regulation( )s controls and regulations over firms were
imposed all over the world the management of the firms improved. +t started disclosing the financial
information for the purpose of analysis and comparison of performance.
0. -rong treatment of )ariou( pro4lem( The traditional approach has been criticied due to its
failure to consider the day'to'day managerial problems relating to finance of the firm.
8. T1e out(i0er@( point of )ie: The traditional approach concentrated itself to looking into the
problems form lender-s the outsider-s point of view, instead of looking into the problems from
management-s the insider-s point of view.
=. O)er emp1a(i( on long term planning The traditional approach over emphasied long'term
financing, lacked in analytical content and placed heavy emphasis on descriptive material.
3. onceptual Omi((ion( The traditional approach neglected the consideration of the "uestion of
the allocation of capital to different assets and the "uestion of optimum combination of finances.
Thus, it omitted discussion on two important matters.
;i< Financing mi> The traditional approach used to give no consideration to the
relationship between financing ? mix and the cost of capital. it failed to deal with the
"uestion of the optimum combination of finances at which the cost of capital is minimied.
;ii< #elation(1ip 4et:een t1e )aluation of t1e firm an0 t1e cot( of capital ) theory of
valuation must be used as a basis for computing the cost of capital. the cost of capital is at
the root of allocating the firm-s funds most efficiently. The traditional approach failed on their
count.
Mo0ern c1ange( in t1e role of financial manager
1. S1ift in emp1a(i( 7 The traditional approach, outlived its utility in the changed business situation
since the mid'1132-s. +ncreasing pace of industrialiation, technological innovations and inventions,
intense competition, increasing intervention of government on account of management inefficiency
and failure, population growth and widened markets etc., during and after mid'1132-s re"uired
efficient and effective utiliation of the firm-s resources, including financial resources. )s the
development of a number of management skills and decision'making techni"ues facilitated to
implement a system of optimum allocation of the firm-s resources, the approach and scope of
financial management changed. The emphasis shifted from episodic financing to the managerial
financial problems, from raising of funds to efficient and effective use of funds.
BSPATIL 0G
0. Anal9tic approac1 The modern approach is an analytical way of looking into the financial
problems of the firm. The central problem of financial policy is the wise use of funds. The central
(rocess involved is a rational matching of advantages of potential uses against the cost of
alternative potential sources so as to achieve the broad financial goals which an enterprise sets for
itself. The basic finance function is to decide about the expenditure decisions and to determine the
demand for capital for these expenditures.
+n his new role, the financial manager, is concerned with the efficient allocation of funds.
The three broad decision areas of modern financial manger are investment financing and dividend
decisions. !e makes these decisions in the most rational way so that the funds of the firm are used
optimally.
Besides his traditional function of raising money, the financial manager today determines the sie and
technology, sets the pace and direction of growth and shapes the profitability and risk complexion of the
firm by selecting the best asset mix and by obtaining the optimum financing mix. !e has to look after profit'
planning which means operating decisions in the areas of pricing, volume of output and the firm-s selecting
of product lines.
O#.ANISATION OF T"E FINANE FUNTION IN LA#.E FI#MS
)s explained in fig. 0.0, +n a large organiation, the finance function is divided between a treasurer and
controller who, in addition to his usual duties as the chief accounting officer of the firm, is assigned some
staff function relating to finance such as financial forecasting, financial control and financial evaluation of
results. +n many large concerns both the treasure and the controller of finance report to a chief financial
officer who often has the title, Kice'(resident'%inance. The division of finance function between controller
and treasurer is scientific, sound and efficient. The division of finance function between controller and
treasurer is scientific, sound and efficient. .hile the controller performs and their analysis, etc, the
treasurer is concerned with the routine functions such as recording of inflow and outflow of cash, credit
management, collection of credit sales etc. The vice'president for finance is in close touch with every
important facet of the operations of his department. !e is usually on of the senior officers of the firm
reporting directly to the president of the firm. ) survey by J.%. .eston in U.#.). in the year of 113=
revealed that in most of the firms the finance officer reported to the president or the board of directors. +n
other cases where he was not a member of the board, he usually attended board meetings in order to
advice and be consulted on financial affairs of the organiation. +n the year 11C0 a survey conducted by
)merican Aanagement )ssociation revealed that while a ma$ority of the companies have a vice president
of finance, the middle sied companies have both a treasurer and a controller. #maller companies have
only treasurer. %inance committee is in some large organisation which directly report to the board directors.
STATUS AN3 3UTIES OF FINANE E$EUTI!E
The nature of the organiation for financial management differs from firm to firm depending on various
factors such as the sie of the firm, nature of the business, kinds of financing operations, capabilities of the
firm-s financial officers and most importantly, on the financial philosophy of the firm.
1. Financial Manager The designation of the financial officer differs from firm to firm and sometimes
he is known as the financial manager, while at other times he is known president of finance or the
BSPATIL 01
director of finance or the financial controller. Treasurer and 4ontroller may be appointed to assist
him. There may be a vice'president of director of finance, usually with both the controller and the
treasurer reporting to him.
0. 1ief Financial Officer The title, vice'president of finance or the finance manger is usually used
for the chief financial officer who has to report diretly to the managing director or the board of
directors or the chief manger of the firm. ) firm may have a finance committee consisting of
members of top management with the chief financial officer as a member. The chief financial officer
has both line and staff responsibilities. 4oncerned with the financial planning and control, he is a
member of top management. )ssociated with the formulating of policies and making decisions for
the firm, he guides the treasurer and controller and others in the effective working of the financing
department.
8. Trea(urer %ollowing are the functions of a treasurer*
;i< To pro)i0e finance The treasurer has to establish and execute programmes for the
provision of the finance re"uired by the business, including negotiating its procurement and
maintaining the re"uired financial arrangements.
;ii< To Impro)e In)e(tor relation( The treasurer has to establish and maintain an ade"uate
market for the company-s securities and to maintain ade"uate contact with the investment
community.
;iii< To Arrange (1ort7term financing The treasurer has to maintain ade"uate sources for
the company-s current borrowings from the money market.
;iv< To maintain Ban,ing an0 cu(to09 The treasurer has to maintain banking arrangement,
to receive and have custody of financial aspects of real estate transactions.
;v< To 0irect re0it an0 ollection( The treasurer has to direct the granting of credit and
the collection of accounts to the company.
;vi< To plan In)e(tment The Treasurer has to invest the company-s funds as re"uired and to
establish and coordinate policies for investment in pension and other similar trusts.
;vii< To pro)i0e In(urance( The treasure has to provide insurance coverage as may be
re"uired.
=. Financial controller %ollowing are the functions of 4ontroller of finance
;i< To Plan an0 to control The controller has to establish, coordinate and administer, as part
of management, a plan for the control of operations. This plan would provide, to the extent
re"uired in the business, profit planning, programmes for capital investing and for financing,
sales forecasts and expense budgets.
;ii< To #eport an0 to Interpert The controller ahs to compare actual performance with
operating plans and standards, and to report and interpret the results of operations to all
levels of management and to the owners of business. To consult with all management about
the financial implications of its actions.
;iii< To A0mini(ter Ta> The controller has to establish and administer tax policies and
procedures.
;iv< To report to t1e .o)ernment The controller has to supervise or coordinate the
preparation of report to government agencies.
BSPATIL 82
;v< To Protect t1e a((et( The controller ahs to assure protection of business assets through
internal control, internal auditing and assuring proper insurance coverage.
;vi< To apprai(e economic an0 (ocial force( The controller has to appraise economic and
social forces and government influences and interpret their impact upon business.
BSPATIL 81
UNIT III
FINANIAL PLANNIN.
3efinition of Financial Planning
1. E(lanning is the process of thinking through and making explicit the strategy and relationships
necessary to accomplish an overall ob$ectivesF
' -illiam 8ing
0. EThe financial plan of a corporation has two'fold aspects * it refers not only to the capital structure of
the corporation, but also to the financial policies which the corporation has adopted or intends to
adoptF
' J/"/ Boune)ille
8. E%inancial planning pertains only to the function of finance and includes the determination of the
firm-s financial ob$ectives formulating and promulgating financial policies and developing financial
proceduresF
' -al,er an0 Boug1am
Thus financial planning is a process consisting of determining the amount of capital re"uired and the
capital structure and laying down the financial policies. +t is not an isolated process but is a part of the
overall planning of any business enterprise.
%ollowing are the three main aspects of financial planning according to .alker and Bougham*
1. Determining financial ob$ectives
0. %ormulating financial policies.
8. Developing financial procedure
1/ 3etermining Financial O4?ecti)e( %inancial planning determines the long term and the short'
term financial ob$ectives. This is necessary to achieve the basic ob$ectives of the firm. %inancial
ob$ectives guide the financial authorities in performing their duties. %inancial ob$ectives may be
long term and short'term.
;+< Long Term o4?ecti)e( The long term financial ob$ective of the firm is to maximie the wealth
of the concern by u"iliing the productive sources of the firm effectively and economically in
such a way as to increase the productivity of the remaining factors of production over the long
run. 7ffective utiliation of productive factors is possible only if there is a regular supply of funds
at minimum cost. Thus long'term financial ob$ectives include ;a< proper capitaliation i.e. to
estimate the amount of capital to be raised and ;b< determining the capital structure i.e. the
form, relationship and proportionate amount of securities to be issued.
;++< S1ort Term O4?ecti)e( The short'term financial ob$ective of the firm is to arrange for the
necessary funds at proper times as and when they are re"uired by the concern for the smooth
running of the business or for the survival of the firm. +t is necessary to maintain the li"uidity of
funds in the business.
*/ Formulating Financial Policie( %inancial planning formulates policies to be followed by the
financial authorities with regard to the administration of capital to achieve the long term and short'
term financial ob$ectives of the firm. %inancial policies serve as guide posts to those associated with
ac"uisition, allocation, and control of funds of the firm. +n formulating policies, the financial manger
is re"uired to forecast future in his endevour to predict the viability of the factors which have their
BSPATIL 80
bearing upon the policies. %orecasting is an integral part of financial planning. The following
financial policies are important.
;i< (olicies regarding estimation of capital re"uirements
;ii< (olicies regarding relationship between the company and creditors
;iii< (olicies regarding the form and proportionate amount of securities to be issued.
;iv< (olicies and guidelines regarding sources of raising capital
;v< (olicies regarding distribution of earnings
;vi< (olicies for the proper administration of fixed and working assets.
+/ 3e)eloping Financial Proce0ure( %inancial planning develops the procedure for performing the
financial activities. %inancial activities are subdivided into smaller activities and powers, duties and
responsibilities delegated to the subordinate officers. (roper control on financial performance or
financial control is possible by establishing standards for evaluating the performance and
comparing the actual performance with the standards so established. #teps are taken to control any
deviation from or inconsistencies in predetermined ob$ectives, policies and programmes. Aethods
used for this purpose include budgetary control, cost'control, analysis and interpretation of financial
accounts etc.
5/ #e)ie:ing Financial Plan )s the management reviews the firm-s short'term ob$ectives, policies
and procedures in the light of changed economic, social and business situation from time to time in
order to keep pace with the changing environment, financial planning is flexible.
IMPO#TANE OF FINANIAL PLANNIN.
1. Better Promotion 7ffective financial planning ensures successful promotion of the business
which is only possible through well thought out flexible financial plan drafted in anticipation of the
establishment of the business.
0. Better 3irection Business operations re"uire funds. #uccessful operation of business depends
on ade"uate and timely availability of finance for the promotion of business, purchase of assets and
raw materials, production and marketing of goods. Thus the success or failure of a firm is closely
linked with financial planning.
8. Better on(er)ation of apital #ound financial planning is necessary for the effective utiliation
of capital. plant and machinery ac"uired by an enterprise become obsolete soon after the arrival of
new machinery in the market with improved technology. Thus, sound financial planning is inevitable
for conservation of capital investment in assets.
=. Better E>pan(ion an0 3e)elopment The ob$ectives of a business enterprise is profit'
maximiation. This re"uires the expansion and development of the business unit for achieving its
optimum operational efficiency. 7fficient financial planning eliminates financial difficulties in the
future expansion and development of the business.
3. More Li<ui0it9 7fficient financial planning makes the firm capable of maintain ade"uate li"uid
funds to meet its obligations to the creditors. )vailability of ade"uate li"uid funds prevents the firm
form the situation of over'trading and strengthens its repayment capacity.
C. "ig1er #eturn on apital Emplo9e0 #ound financial planning leads to effective utiliation of
capital by avoiding both under ? capitaliationB and over ? capitaliation both of which are harmful
to the financial interests of a corporation. Thus, efficient financial planning leads to higher return on
BSPATIL 88
capital employed by the firm.
D. Optimal apital Structure at Minimum o(t 7fficient financial planning leads to the optimal
capital structure of the firm at minimum cost. +n deciding the ratio of different forms of capital in total
capital of the firm, the financial manager ensures that the firm pays the least cost and incurs less
risk. )fter analying the costs and risks involved in different forms of capital, he finally selects those
which involves the least cost without much risk.
G. Better unit9 an0 o7or0ination %inancial planning leads to the most effective utiliation of the
firm-s capital by establishing effective co'ordination in different operative function and unity in action
by all executives at different levels. Thus, it serves as a guide to effective co'ordination among
various operative function and unity in action. )t different levels the executives follow financial
policies, procedures and ob$ectives as set out in the financial plan.
1. #eplacement of o4(olete a((et( +n the present dynamic economic world, price levels keep on
changing fast rendering the replacement cost of the firm-s assets much higher than its ac"uisition
cost. ,eplacement of obsolete assets is possible only through financial planning.
12. Fa(ter .ro:t1 of Pu4lic Sector Today growth of public sector has intensified the need for
effective financial planning for the private sector. The public sector enterprises procure borrowed
capital from commercial banks and specialied financial institutions. !ence the private enterprises
find it difficult to obtain the necessary funds from these institutions for financing their plans.
Therefore, the business enterprises should forecast their financial re"uirements well in advance by
means of effective financial planning.
"A#ATE#ISTIS OF SOUN3 FINANIAL PLAN
1. Simple )n ideal financial plan is easily understandable to all. +t is free from complications and
suspicions. There are not too many securities likely to create complications in the financial plan and
confusion in the mind of the potential investors about their nature and profitability. #implicity of
financial plan helps the management in procuring the necessary capital.
0. Fore(ig1te0 7fficiency of a firm-s financial plan depends upon the determination of its scope and
sie of activities. Thus, financial plan needs to be drafted after estimating the present as well as
future financial re"uirement of the firm. +n order to arrive at a sound financial plan the promoters
use foresight in predicting the short'term and long'term financial needs of the company.
8. Fle>i4le The capital structure of a company should be flexible enough to make necessary
ad$ustment in it according to the changing circumstances. The flexibility in the financial plan enables
the company to introduce necessary changes to it according to the changing business situations.
The company may need additional capital for financing schemes of moderniation, automation,
expansion of business, employee welfare etc. The capital may e increased by issuing new shares
or debentures to the public or by raising loans from specialied financial institutions but reduction of
ordinary share capital is not permissible. #hort'term financial re"uirements may be met by term
loans or issue of redeemable preference share capital. rigidity in capitaliation and capital structure
restricts and progress of the business and unnecessarily limits its activities.
=. Li<ui0 To business operations, smooth and reasonable percentage of current assets should be
kept in the form of li"uid cash. The business operations may be adversely affected in the absence
of ade"uate li"uid cash. .hile formulating the company-s financial plan, it is necessary to pay
proper attention to the li"uidity re"uirements of a firm which depends upon the nature and sie of its
business, its credit standing, goodwill and situation on trade cycles.
3. Pro)i(ion for ontingencie( ) good financial plan has a ade"uate provision for business
BSPATIL 8=
oscillations and anticipated contingencies. Trade cycles are the general phenomenon of the
economic world. During depression period, it is difficult for a company to procure the minimum
amount of working capital by issuing e"uities as the investors cannot be interested in investing their
savings in e"uities if there is no guarantee of dividend on them. They would rather prefer to invest
in fixed income securities such as debentures, preference shares, etc. therefore, it is advisable that
the company promoters anticipate the possible contingencies does not always imply the
maintenance of surplus capital. it refers to provision for these contingencies, i.e., either by internal
financing or by issuing new securities.
C. Economical The promoters should always keep in mind the cost of capital procurement while
formulating the financial plan. The various expenses relevant to the issue of capital such as
underwriting, brokerage, discount, printing, etc., should be the minimum.
D. Inten(i)e U(e of apital 7ffective utiliation of capital is as much important as the procurement
of ade"uate funds. This is possible by maintaining e"uilibrium in fixed and working capital.
surpluses of fixed and working capital should not be used as substitutes to shortages of one
another. #uch practices should not be encouraged as they would drag the company to financial
crises. Thus, intensive use of capital for a fair capitaliation. &ver'capitaliation and under ?
capitaliation both are harmful to financial interests of a corporation.
FATO#S AFFETIN. FINANIAL PLAN
1. Nature of In0u(tr9 The financial planning of an enterprise is directly related to nature of industry.
.hile capital ? intensive industries re"uire large amount of capital, labour'intensive industries
re"uire relatively small amount of capital. stability and regularity in earnings of the industry,
variation in demand of goods manufactured, possibilities of future development, extent of control on
production process, scientific progress, etc., also affect the "uantum of capital and sources of
finance of a company. +ndustries having stability and regularity in earning can easily procure capital
from the market.
0. SiAe of In0u(trial Unit %inancial plan is affected by sie, area of operation, goodwill of
managers, reputation etc. Barge sied and old in industries with established goodwill do not face
difficult in raising the needed capital, while newly promoted industries enterprises face a lot of
difficulties in collecting the re"uired amount of capital.
8. Amount of #i(,( %inancial plan is affected by the amount of risks involved in the process of
production of an enterprise. +ndustries with greater amount of risks need relatively more capital.
these mainly depend upon the ownership securities for the procurement of the re"uisite capital.
industries with lesser amount of risk can easily obtain loans and earn higher profits for e"uities.
+ndustries having more risks and uncertainties do not financial li"uidity, and debt'financing usually
harmful to such enterprises.
=. Programme of E>pan(ion %inancial planning is affected by the programmes of expansion and
diversification of the business enterprise in future. Thus, while formulating the financial plan, the
promoters should keep in view the future expansion and diversification programmes of the
corporation. +n the absence of flexibilities in the financial plan, it is difficult to raise the necessary
capital in future for financing the proposed programmes of expansion and diversification.
3. apital (tructure The capital structure of the corporation should be balanced, diversified and of
high grade securities. There should be reasonable balance between different securities. The
company should retain some ideal securities so that capital may be raised immediately by issuing
them at the time of financial crises.
BSPATIL 83
C. A)aila4ilit9 of Alternati)e Source( of Finance The financial plan of an enterprise depends
upon the availability of the alternative sources of finance at the time of need. The alternative
sources of finance should be appraised in the light of their cost, profitability, control on business,
views of the management etc. &nly those sources of finance should be selected which are most
favorable to the firm.
D. Fle>i4ilit9 %lexibility is the main principle to be followed in the financial planning. +f there is no
flexibility in financial plans, it would be difficult to carry on its expansion or diversification
programmes due to lack of funds.
G. E>ternal apital #e<uirement +t is good policy for the industry to finance its expansion or
diversification programmes through resources such as ploughing back of profits, reserves and
surplus etc. #hort'term finances may be obtained from external sources by issuing redeemable
preference shares or debenture if they are urgently needed.
1. Altitu0e of Management The financial plan is also affected by the attitude of the management of
the industrial unit. +f the existing owners and management wish to retain the control of business in
their hands, they would not like to issue e"uity shares in large "uantity. +f they do so, they would
purchase a ma$ority of such shares themselves. They would prefer debt capital even for expansion
or diversification or diversification programmes in future. (loughing back of profit is preferred in
such business enterprises.
12. .oal ontrol 6overnment policies, financial controls and statutory rules and regulations should
be considered while formulating a sound financial plan. %or example, under the 4apital +ssues
4ontrol )ct., 113C a company in +ndia is re"uired to obtain the approval of the controller of capital
issues at the time of issuing shares or debentures to the public, and such approval is given only if
the present security ? mix of the corporation is ideal.
LIMITATIONS OF FINANIAL PLANNIN.
1. Not e>act Foreca(ting Being based on financial forecasts, no financial plan can exactly predict
the future economic and business environment. +f forecasting is wrong, the financial plan would be
ineffective. Therefore, a financial plan should be periodically reviewed and necessary changes must
be made in accordance with the changing economic and business environment.
0. Lac, of co7or0ination +f there is not effective co'operation and co'ordination among various
officials of the corporation, it is difficult to implement even the ideal financial plan successfully, and
the financial plan proves unsuccessful and ineffective.
8. 1ange( in Economic on0ition( an0 .o)t/ Policie( 4hanges in economic condition and
government policies exert adverse influence on the effectiveness of a financial plan.
=. #igi0 !ie: +f the financial managers follow a rigid view regarding the financial plan of
corporation, and hesitate in making necessary ad$ustments in it effective financial plan also become
ineffective for want of necessary ad$ustment according to the changing economic and business
conditions.
UNIT I!
APITALI%ATION
MEANIN. OF APITALI%ATION
1. Broa0 Meaning +n its broad sense, capitaliation is synonymous with financial planning, covering
BSPATIL 8C
decisions regarding the amount of capital to be raised, the relative proportions of the various
classes of securities to be issued and the administration of capital.
0. Narro: Meaning +n its narrow sense, capitaliation means the amount at which a firm-s business
can be valued, the sum total of all long'term securities issued by a company and the surpluses not
meant for distribution. +t is composed of the accounting value of the capital stock, value of surplus
not meant for distribution and the value of long term debts. Thus the narrow interpretation of
capitaliation deals with only "uantitative aspect of financial plan, leaving the "ualitative aspect of
financing out of its scope.
3efinition( of capitaliAation
1. E4apitaliation is the total accounting value of the capital stock, surplus in whatever form it may
appear, and long'term debtsF
' 3ori(
0. EThe term capitaliation, or the valuation of the capital includes the capital stock and debtsF.
' A/ S/ 3e:ing
8. E4apitaliation refers to the sum of the outstanding stocks and funded obligaiotns which may
represent wholly fictitious valuesF
' E/F/ Lincoin
=. E%or all practical purposes, capitaliation means the total accounting value of all the capital regularly
employed in the businessF.
' ./-/ .er(ten4erg
3. EThe term capitaliation is used to mean the total of the funds raised on a long term basis, whether
debt, preferred, e"uity or common e"uity. The common e"uity, of course, includes all values
belonging to that interest and not merely stated value of the common stock.
' Pear(on an0 "unt
C. E4apitaliation includes the amount of capital to be raised, the securities through which is to be
raised and the relative proportion of various classes of securities to be issued and also the
administration of capitalF.
' -/"/ "u(4an0 an0 3// 3oc,erar9
ONTENTS OF APITALI%ATION
1. The value of shares of different classes, i.e., ordinary shares and preference shares.
0. The value of all surplus, whether capital or earned, not meant for distribution.
8. The value of bonds and debentures issued by a company still not redeemed, and
=. The value of long'term loans secured by the company other than bonds and debentures.
APITALI%ATION AN3 APITAL
4apital and capitaliation are two different terms although the term EcapitaliationF has been derived from
the word EcapitalF. The term EcapitaliationF is used only in relation to companies and not in respect of sole
proprietorship or partnership firms. +t represents total investment or resources of a company. .hile the
share capital of a company refers to the total paid up value of shares issued by a company, capitaliation
includes the share capital, debenture stock, long'term debt and the surplus not to be distributed. This
BSPATIL 8D
capital is one part of capitaliation, as is clear by the following.
#hare capital 9 7"uity #hare 4apital L preference #hare 4apital
4apitaliation 9 #hare 4apital L Debenture 4apital L Bong'term borrowing L
%ree ,eserves
"O- TO ESTIMATE APITAL #EBUI#EMENTSC
.ise estimation of capital re"uirements of a company is necessary for the smooth functioning of a
business. +f the amount of capital is more tan what is really needed to fun the business, a part of funds
would either remain idle or be invested wastefully. &n the other hand, if the amount of capital is less than
what is re"uired for the smooth running of business operations the company would face shortage of funds
for one activity or another. +n order to avoid both of these situations, the %inancial Aanager should carefully
examine various re"uirements of funds by the company for promotion, organiation and establishment of
business. !owever the financial Aanager should also keep in mind the future re"uirements of funds for
expansion and growth of the company, while estimating the total capital needs. &n the other hand, while
estimating the capital re"uirements of a newly promoted company, the financial manager should give due
consideration to the following factors.*
1. E>pen(e( for Promotion ,e"uired is case of a new company, these include'expenses incurred
on discovery of business idea and examining its viability, registration of the company, establishment
of organiation, commencement of business etc.
0. o(t of Fi>e0 A((et( 7 %ixed assets including land and building, plant and machinery, furniture
and fixtures, etc., need a careful capital re"uirements estimation.
8. o(t of urrent A((et( This is the capital re"uires for financing the ac"uisition of current assets
such as stocks, debtors, bills receivables, prepaid expenses etc.
=. o(t of Financing 7very company has to incur a huge amount of expenditure for raising finance
which include advertisement, listing, brokerage, commission etc.
3. o(t of Fictitiou( A((et( Aost of the companies re"uire to pay huge amount for purchase of
intangible assets such as goodwill, patents, trade mark, etc.
C. o(t of Su(tenance an0 3e)elopment .hile in the initial years, a business may need funds to
meet its losses, in later years, it needs funds for diversification, expansion and growth, as well as
for replacement and renovation of old fixed assets, moderniation, innovation, research and
development, etc.
T"EO#IES OF APITALI%ATION
+n order to determine the capital re"uirements of a newly promoted company the following two theories of
capitaliation are generally employed.
1. o(t T1eor9 of apitaliAation )ccording to cost theory, the amount of capitaliation in e"ual to
the total cost incurred in setting up of a corporation as a going concern. Thus the estimation of
capital re"uirements of a newly promoted company is based on the total initial outlays for setting up
of a business enterprise. The amount of capitaliation of a company, is determined by aggregating
the following*
;i< The cost of fixed assets, such as land and building, plant and machinery, goodwill, patents,
furniture and fixture, etc.
;ii< The amount of regular working capital re"uired to carry on business operations.
BSPATIL 8G
;iii< The expenses of promotion.
;iv< The cost of establishing the business.
The original outlays on all these items form the basis for determining the amount of capitaliation. This
theory enables the promoter to know the total initial amount of capital which they should raise. +t is suitable
for determining the financial re"uirements or the amount of capitaliation of a newly promoted corporation.
A3!ANTA.ES OF OST T"EO#=
The cost theory is useful for those enterprises in which the amount of fixed capital is more and whose
earnings are regular, such as construction and public utility institutions.
3ISA3!ANTA.ES OF OST T"EO#=
;i< This theory suffers from the basic drawback that the amount of capitaliation is $udged by a
figure based on the cost of establishing and starting a business, and not by its earning. +t fact,
the amount of capitaliation is determined by what a firm earns and not by what ha been
invested in it. This theory does not explain whether the capital invested in a business is $ustified
by its earnings.
;ii< This theory is not satisfactory in the case of a growing concern whose earnings keep on
changing whereas the amount of capitaliation remains constant.
;iii< This is not useful for those enterprises in which the operating cost is changing, earnings are not
regular and certain, and which carry on their business under competitive conditions.
0. Earning T1eor9 of apitaliAation )ccording to this theory the real worth of a business
enterprise is determined by ;i< its earning capacity, ;ii< its annual earnings. )s the basic ob$ective of
an enterprise is to earn profit, the amount of capitaliation for it should be in accordance with its
earnings. The value of capitaliation of a company is e"ual to the capitalied value of its estimated
earnings. Thus, the process of capitaliation begins with the estimation of future earnings of the
company. The manager forecasts sales and production costs of the company to arrive at the
estimated earnings which are, then, compared with he actual earnings, of other companies of
similar sie carrying on the similar business. 5ow for determining the amount of capitaliation the
rate of earnings in similar companies is applied to the estimated annual earnings of the company.
The amount of capitaliation of a company can be computed by using the following formula.
)mount of 4apitaliation ' 7stimated )nnual 7arnings x ,ate of
4apitaliation
;i< Annual Earning( ? The probable earnings of an established company estimated on the
basis of average of earnings during the past year. ,eal estates of possible future earnings
may be had by considering the various internal and external factors affecting the annual
earnings of the company. +t is very difficult to forecast the amount due to the reason that the
earnings newly promoted companies depend upon various other factors besides
capitaliation, such as general price level, elasticity of demand, operating costs, extent of
competition, industrial ands tariff policies of the government etc. The net income of the
newly promoted companies may be forecasted on the basis of estimates of operating costs
and volume of sales based on the experience of the promoters or management. %or
ascertaining the reliability and accuracy, these estimates should be compared with the
actual figures of costs and sales of existing companies in sie, age, location level of
management, rate of growth and other similar factors. )fter deducting the operating costs
from the operating income the net earnings arrived at may be used for determining the
BSPATIL 81
amount of capitaliation.
;ii< #ate of apitaliAation ? This is necessary for determining the amount of capitaliation of a
company. The annual net earnings of a company are capitalied at the rate of capitaliation.
+t may be determined by studying the rate of return in similar companies in the same
industry. +t should reflect ade"uate return to the investors for the use of their funds and the
risk they undertake. +t may be calculated with the help of average price earnings ratio, which
is computed on the basis of income and market value of share of other firms in the industry.
!owever, determination of capitaliation by price'earning ratio is considered suitable only
when the entire capital is raised by issuing shares.
!rice "arning #atio $ !rice !er %hare &"quity %hare'
(((((((((((((((((((((((((((((((((((((((((((((
"arning !er %hare &"quity %hare'
O!E# APITALI%ATION
) company is over'capitalied when its earnings are consistently insufficient to yield a fair rate of return on
the amount of capitaliation of a company and when it is not in a position to pay interest on debentures and
long'term borrowing, while dividends on shares are not at fair rates, it is said to be overcapitalied. This
situation arises when a company raises more capital than what is $ustified by its actual earnings. &ver
capitaliation does not necessarily mean abundance or excess of capital. an over'capitalied company
may be short of capital. ) company may be over'capitalied because its capital is not effectively utilied,
thus causing a constant decline in earnings. This leads to the inability of the company to pay normal rate of
dividend and interest on shares and debentures respectively. +t leads to fall in the market value of its
shares. ) company is overcapitalied if it has been unable to earn a fair or prevailing rate of return on its
capital, and the market value of its shares is lower than the book value over a fairly long period of time.
3EFINITIONS OF O!E#7APITALI%ATION
1. E) corporation is over ? capitalied when its earnings are not large enough to yield a fair return on
the amount of stocks and bonds that have been issued, or when the amount of securities
outstanding exceeds the current value of the assetsF.
' /-/ .er(ten4erg
0. E.hen a company has consistently been unable to earn the prevailing rate of return on its
outstanding securities ;considering the earnings of similar companies in the same industry and the
degree of risk<, it is to be over'capitaliedF.
' "aro0 .il4ert
8. .henever the aggregate of the par value of stock and bounds outstanding exceeds the true value
of fixed assets, the corporation is said to be over'capitaliedF.
' "oaglan0
"A#ATE#ISTIS OF O!E#7APITALI%ATION
1. Bower rate of earning than prevailing in similar companies in the same industry over a fairly long
period of time.
0. Bower rate of dividend over a long period of time.
BSPATIL =2
8. Bower market value of shares than the book value of shares over a long period of time.
AUSES OF O!E#7APITALI%ATION
1. "ig1 Promotional E>pen(e( ) company has paid high promotional expenses in the form of
payments to promoters for their services, and excessive price for goodwill, trade marks, patents,
copyright etc. #imilarly, if the company is formed by converting a partnership firm or a private
limited company into a public limited company and the assets transferred at highly inflated prices,
the company will be over'capitalied because the book value of the company-s assets will be higher
than its real value.
0. Purc1a(e of a((et( 3uring Inflationar9 on0ition( +nflationary conditions affect both the newly
promoted as well as the established companies. companies have to pay high prices for purchase of
fixed assets, and the amount of capitaliation is kept high during boom period. But after the boom
conditions subside and necessary conditions set in, the real value of the company-s assets fall
while the book value of its assets remain at a higher level therefore, the company becomes over'
capitalied.
8. #ai(ing E>ce((i)e apital &ver ? capitaliation occurs if a company raises excessive capital
than what it can utilie effectively. )s a large amount of capital remains idle and ineffectively
utilied, the company-s earnings decline leading to fall in market value of its shares.
=. S1ortage of apital (aucity of capital is the result of faulty financial planning. +f compels the
company to borrow capital at very high rates of interest. ) large chunk of profits is given away to
the creditors as interest leaving little to be distributed to the shareholders as dividends. )s the rate
of dividend falls the market value of shares also fall showing over'capitaliation.
3. Borro:ing at "ig1er Intere(t #ate( To meet its emergent needs if a company borrows a large
amount of capital at a rate of interest higher than the rate of its earnings it will be over'capitalied.
)s a ma$or part of its earnings will be taken away by the creditors as interest, the rate of dividend
will fall, and the market price of shares would decline. Thus, lower market price of shares than the
book value makes the company over'capitalied.
C. O)er7e(timate of Future Earning( )s the promoters of mangers over'estimate the earnings of
the company, it results in over'capitaliation.
D. O)er7estimate of 4apitaliation ,ate ? ) company would be over'capitalied if the earnings are
correctly estimated but the rate of capitaliation is under'estimated. Underestimate of the rate of
capitaliation results in raising excessive capital than what the company could utilie profitably
making the company unable to distribute dividends at prevailing rates. This leads to decline in the
market value of its shares which is a symptom of over'capitaliation. %or example, if a company-s
regular earnings of ,s. 1,32,222 and capitalied at CM the total amount of capitaliation would be
,s. 03,22,222. +f later on, it is found that the rate of capitaliation is 12M instead of CM, the amount
of capitaliation should be ,s.. 13,22,222. Thus, the excess amount of ,s. 12,22,222 would lead to
over'capitaliation.
G. Ina0e<uate Pro)i(ion for 3epreciation Due to inade"uate provision for depreciation and
replacement of assets, a company is able to distribute higher dividends to its shareholders only for
a few years. !owever, with the passes of time the working efficiency of fixed assets decreases
resulting in a fall in the earning capacity of the company. Therefore, the share prices of the
company show a declining trend indicating over'capitaliation.
1. Li4eral 3i)i0en0 Polic9 +f, instead of ploughing back its profit a company prefers to follow a
liberal dividend policy it would find it difficult to replace its worn'out assets with sufficiently
BSPATIL =1
decreased working efficiency. +t will be compelled to resort to costly borrowing which adversely
affects its earning capacity. The combined effect of these factors leads to company to over'
capitaliation over a long period of time.
12. #igorou( Ta>ation Polic9 ,igorous taxation policy of the 6overnment results in over'
capitaliation. Due to higher tax burden, very little amount is left with the company for dividend
distribution among the shareholders at prevailing rate, a symptom of over'capitalisation. The
company may face shortage of funds form both working capital as well as for financing the
renewals and replacement of worm'out assets. Thus, the working efficiency of the company
decreases. The prices of its shares fall resulting in the company-s over'capitaliation condition.
3ISA3!ANTA.ES OF O!E#7APITALI%ATION
1/ 3ISA3!ANTA.E OF T"E OMPAN=
;i< Set 4ac, in t1e !alue of S1are( an0 .oo0:ill Because of decrease of in the earning
capacity of the company, a large ma$ority of investors lose their confidence in the company.
The market value of its shares comes down and the company-s financial stability is
$eopardied. +t also suffers a set back to its goodwill.
;ii< Set 4ac, O4taining apital 7Because of fall in dividends the investors lose their confidence
in the company resulting in difficulty to obtain the re"uisite capital for improvement and
ac"uisition of new assets by issuing shares or debentures.
;iii< Set 4ac, in o4taining Loan( The credit standing and goodwill of an over'capitalied
company suffers a set back due to falling earnings. %inancial institutions hesitate in
providing loans to such a company for its development and expansion programmes.
;iv< Manipulation of Account( )n over ? capitaliation company resorts to ob$ectionable
practices including manipulation of accounts in order to cover up the deficiency of the
decreased earnings and to present a respectable figure of profits. +t does not make
ade"uate provisions for depreciation, maintenance, renewal and replacement of asset. +t
even declares and pays unearned dividends from capital to revive its decreasing credit
standing. This further aggravates the decreasing value of the company besides misleading
the investors.
;v< 3eman0 for Li<ui0ation )n over'capitalied company is not able to pay the principle
amount of loan and interest there on. Therefore, the creditors may forcefully demand
li"uidation of the company, unless drastic steps are taken to correct the situation.
,eorganiation of the company-s share capital, is one effective remedy leads to
considerable loss of its goodwill.
;vi< A4(ence of ompetiti)e (trengt1 Due to its failure to produce goods at competitive cost
on accounts and inade"uate provision for depreciation, repairs, maintenance and
replacement of assets an over'capitalied company loses its market to competitors. #uch a
company is unable to provide facilities to their customers e"ual to its competitors. Therefore,
it fails to retain its customers and lose the market.
*/ 3i(a0)antage( to (1are1ol0er(
;i< Lo: 3i)i0en0 The shareholders of an over'capitalied company suffer a revenue loss
due to low return on their investment in the form of low dividends on account of low earnings
of the company.
;ii< Lo: Mar,et )alue of S1are( The shareholders suffer a capital loss on account of low
BSPATIL =0
market value of shares. They have to sell their share below par, suffering a capital loss
through depreciation of their investments.
;iii< Lo(( on #e7organiAation or Li<ui0ation +f an over'capitalied company attempts to
overcome its ills by re'organiation or li"uidation, the shareholders are the worst sufferers.
,e'organiation calls for reduction in capital for writing off past losses, leading the reduction
of par value of shares resulting in depreciation of the shareholders investments. +f an over'
capitalied company is forced by its creditors to go into li"uidation, the shareholders are the
recipients of the residual amount left after the payments to creditors. #ometimes the
shareholders have to forego the entire amount of their investments in case of li"uidation.
;iv< Lo: !alue of S1are( a( ollateral Securitie( )s the shares of an over'capitalied
company are not easily marketable due to low earnings and lower dividends of the
company, they have a lower value as collateral securities. 4ommercial banks and other
financial institutions are not willing to sanction loans against such securities. 7ven if they
agree to grant such loans, they insist upon strict terms and conditions hardly acceptable to
an ordinary borrower.
;v< Encouragement to Speculati)e .am4ling )s the low'priced shares of an over'
capitalied company are sub$ect to speculative gambling, the real investors have to suffer
on account of this manipulation.
+/ 3ISA3!ANTA.ES TO SOIET=
;i< Lo:er Bualit9 an0 "ig1er Price( )n over'capitalied company does everything to
increase its earnings. +t reduces the "uality and increases the price of products. The
ultimate consumers suffer in terms of both "uality and price and have to pay high prices for
poor "uality products.
;ii< #e0uction in -age( an0 La4our -elfare Acti)itie( &ver ? capitaliation leads to
retrenchments and reduction in wages and salaries. )n over'capitalied company tries to
cut the wages and welfare facilities of the workers creating soreness in industrial relations.
The interests of the workers suffers due to substantial cuts in wages and other benefits. )n
over'capitalied company often resorts to retrenchment of the workers on grounds of low
earnings in the company.
;iii< #ece((ion Due to low purchasing power of workers, demand for goods comes down. )s
this process continues recessionary conditions are witnessed.
;iv< Unemplo9ment %inding it difficult to survive in the competitive market over'capitalied
companies is often forced to close down. The closure of a few over'capitalied companies
tends to create panic in general. +ndustrial activity receives a set back. The consumers are
deprived of goods and services. The creditors lose their credits. The workers lose their $obs.
The society is confronted with a depressing effect in general.
;v< Mi( 7 utiliAation an0 -a(tage of #e(ource( )n over'capitalied company is unable to
effectively utilie the society-s resources. Thus over capitaliation leads to the wastage of
national resources which could be used most effectively by those efficient companies who
are in need of funds.
;vi< Encouragement of Speculation The shares of an over'capitalied company are
invariably sub$ect to speculative gambling.
;vii< Fru(tration Among In)e(tor( &ver'capitaliation leads to reduced efficiency and
BSPATIL =8
possibility of failure of the business. Therefore, the investors are not willing to invest in such
a company. The industrial and economic development of the country is adversely affected.
#EME3IES TO O!E#7APITALI%ATION
%ollowing are the remedies to over'capitaliation*
1/ #e0uce0 Fun0e0 3e4t ? To control the situation of over'capitaliation, a company reduces the
amount of funded debts through outright re'organiation. Debentures and bonds are immediately
redeemed out of accumulated earning or new issues. !owever, as the profits of an over'capitalied
company are very low, it is very difficult for it to raise the necessary funds from the market. +f it
issue its shares at a discount, it may do more damage to the company. Thus, reduction in capital
may be affected only by retiring the funded debts out of accumulated earnings.
*/ #e0uce0 Intere(t #ate in 3e4enture( )n over'capitalied company tries to reduce its fixed
obligation with regard to payment of interest on debts. +t persuades the existing debenture holders
to accept new debentures carrying lower rates of interest, on some premium for this concession.
+/ #e0emption of Preference S1are( The amount of capitaliation may be reduced by redemption
of performance shares carrying high rate of dividend. This poses the same problem as in case of
redemption of debentures by issuing new shares at a reduced price. ,aising of necessary funds for
redeeming the high dividend preference shares may further aggravate the situation.
5/ #e0uce0 Par !alue of S1are( The existing shareholders are persuade to accept new shares
with reduced par value. This reduces the amount of capitaliation and improves the earning
capacity of the company. !owever, this is possible only if the management is able to convince the
existing shareholders that reduction in par value of shares is in their interest.
6/ #e0uce0 Num4er of S1are( ) company sometimes reduces the number of shares to correct the
situation caused by over'capitaliation. The shareholders may be given one share of the same
amount in exchange of several shares. Thus earning per share goes up without affecting the
amount of capitaliation. This helps the company in raising the necessary funds for future
development.
D/ Ploug1ing Bac, of Profit( +n the initial stage of over'capitaliation, the company may resort to
the ploughing back of profits by suspending the distribution of dividends for a few years. This
increases the amount of its real value without an extra burden on its resources. The management
should make all'out efforts to eliminate wasteful expenditure and to increase the efficiency of the
company-s resources.
UN3E# APITALI%ATION
MEANIN. OF UN3E# APITALI%ATION
Under ? capitaliation is the reverse of over'capitaliation. ) company is under'capitalied when its
earnings are high in relation to other similar firms in the industry, or when it has very little capital to conduct
its business, or when the real value of asset are more than the book value. under'capitaliation is
associated with an effective utiliation of investments, an exceptionally high rate of dividend and prices of
shares. +t is a condition where the real value of the company-s assets is more than the book value.
3EFINITIONS OF UN3E# APITALI%ATION
1. E) 4orporation is under'capitalied when the rate of profit it is making on the total capital, is
exceedingly high in relation to the return en$oyed by similarly situated companies in the same
industry, or when it has too little capital with which to conduct its business.
BSPATIL ==
' /-/ .er(ten4erg
0. E.hen a corporation earns exceedingly high income on its capital, it is said to under'capitalied.F
' Bonne)ile an0 3e:9
8. E.hen a company is earning considerably more than the prevailing rate on its outstanding
securities, considering the same factors, it is said to be under'capitaliedF.
' ./ "arol0
%ollowing are the #ymptoms of under'capitaliation
1. "ig1er rate of Earning The rate of earning is exceedingly higher than prevailing is similarly
situated companies in the same industry.
0. "ig1er rate of 0i)i0en0 This is as compared to the rate declared by other similar companies.
8. "ig1er !alue of S1are( The real and market value of shares is higher than their book value.
=. "ig1er )alue of A((et( The real value of the company-s assets is higher than their book value.
AUSES OF UN3E# APITALI%ATION
1. Un0er E(timation of Earning The amount of capitaliation is less than what a company can
utilie effectively, if the promoters under'estimate the future earnings of the company while
formulating the financial plan. The company becomes under'capitalied as the earnings in
subse"uent years prove to be higher.
0. Un0er7e(timation of capital re<uirement( +f the promoters under'estimate the capital
re"uirements of the company, the amount of capitaliation if low. Thus, the company becomes
under'capitalied due to inade"uacy of capital.
8. Promotion 0uring #ece((ion +f a company is promoted during the period of recession, it may
ac"uire the assets at cheaper prices. The real value of the assets automatically goes up with the
end of recession. Thus, during boom period its earnings increase proportionately higher than the
increase in the amount of capital employed, resulting in high profits to the company and
exceptionally higher rate of dividends as well as higher market price of its shares making the
company under'capitalied.
=. Unfore(een Increa(e in Earning( Due to government liberal policy towards a particular industry,
or increases in sale price of the product due to sudden increase in its demand, the earning of a
company may increase abnormal making in under capitalied.
3. on(er)ati)e 3i)i0en0 Polic9 +f a company follows a sound and conservative dividend policy
leading to the creation sufficient reserves for depreciation, repairs and renewals, and the ploughing
back of profits, its earnings increases tremendously, and real value of its assets exceeds their book
value indicating under'capitaliation.
C. Promoter@( 3e(ire to ontrol +f the promoters of a company seek to retain its control within the
hands of a few persons, they issue lesser number of shares, and raise a large portion of its capital
by issuing securities bearing low rate of interest. The amount of divisible profits available to the
shareholders is exceptionally high and the company becomes under'capitalied.
D. "ig1 Stan0ar0 of Efficienc9 +f a company follows the policy of rationaliation and moderniation
entailing the use of latest production techni"ue and efficient management of resources, its profits
BSPATIL =3
invariably increase exceedingly. +t may also increase it earnings by creating large secret reserves,
ploughing back of profits, maximiing productivity, minimiing wasteful use of resources, etc. )s a
result the real value of its assets becomes much higher than their book value, and the company
becomes under'capitalied.
G. Lo: Promotion E>pen(e( The company will become under'capitalied if the promoters do not
charge excessive amounts for their promotional services and the over'all promotional cost is kept
very low.
1. Li4eral Polic9 Due to low tax burden, sufficient amount is left with the company for higher
dividend distribution, a symptom of under'capitaliation. Biberal tax policy enables the company to
increase its working efficiency by maintaining ade"uate reserves of financing the renewals and
replacement of worn'out assets.
12. apital .ain( +f a company-s assets are sold by the management at higher price than their book
value, the resultant capital gains lead the company to under'capitaliation.
3ISA3!ANTA.ES OF UN3E#7APITALI%ATION
1/ 3ISA3!ANTA.ES TO T"E OMPAN=
;i< More Speculation ) high divided rate on the shares of an under'capitalied company leads
to high market "uotations of these shares. The management may manipulate share values and
enter into speculation of these shares.
;ii< Limite0 Mar,eta4ilit9 of S1are( )s the existing shareholders do not generally want to
dispose off such shares, the marketability of an undercapitalied company-s share is
considerably reduced.
;iii< ut t1roat competition )s higher earnings of the existing under'capitalied companies
attract new competitors to enter the business, cutthroat competition among rival companies
tends to grip the business and reduce its profitability.
;iv< In0u(trial Unre(t +ndustrial relations in under'capitalied companies tend to be strained on
account of the fact that employees begin to ask for higher wages, bonus, reduced working
hours, increased welfare facilities etc., out of he increased prosperity of the company in the form
of higher earnings. This leads to industrial unrest which adversely affects the efficiency of the
corporation leading to decline in its profits.
;v< on(umer( Oppo(ition Due to high earnings, the consumers of an under'capitalied
company feel that they are being cheated by overcharging the prices for its products. This may
lead to the consumer agitations for a reduction in prices of the products offered by an
undercapitalied company. They may demand state intervention to control the prices of the
products of such a company. This would result in reduction in the profits of the company.
;vi< Interference 49 .o)ernment Declaring a high rate of dividend, an Under'capitalied
company attract the government interference to cut down the prices of its products, to profit
ceiling, to charge high profit taxes or file a suit against such a company under anti'trust laws of
the country.
;vii< Ina0e<uac9 of apital #uffering from shortage of capital an under'capitalied company
always depends on borrowed funds. #ometimes, it is compelled to borrow funds at a high rate
of interest resulting in reduction of its earnings and control by its creditors, who may even
demand for its li"uidation in case of non'payment of interest and the principal amount of loan.
BSPATIL =C
;viii< O)er7capitaliAation Under'capitaliation also leads a company to over'capitaliation in the
long'run due to huge retained earnings and long'term debt financing.
A3!ANTA.ES OF UN3E# APITALISATION
A/ A3!ANTA.ES TO S"A#E"OL3E#S
1. "ig1er 3i)i0en0( The shareholders of an under'capitalied company regularly receive higher
dividends on their investments, due to higher earnings of the company.
0. More apital .ain( The shareholders of an under ' capitalied company also avail more capital
gains, because the market value of the company-s shares increase very rapidly.
8. Ea(ier Loan( )s the shares of an under'capitalied company have great value as collateral
security, the shareholders get easier loans against the security of shares of an under'capitalied
company.
B/ A3!ANTA.ES TO SOIET=
;i< .eneral :elfare The entire society is benefited with the higher earnings of an under'
capitalied company
;ii< Emplo9ee( a0)antage The employees get higher wages, bonus and better amenities.
;iii< Increa(e0 Pro0uction Under'capitaliation encourages the establishment of new companies
resulting in increased industrial production and ensuring regular supply of "uality goods to the
consumers at cheap prices.
;iv< Increa(e0 emplo9ment 7stablishment of new companies and expansion of the established
ones creates increased employment.
#EME3IES TO UN3E#7APITALI%ATION
%ollowing are the remedies to under employment
1. Splitting up of S1are( The shares of an under'capitalied company may be splitted into shares
of small denomination bringing down the amount of divided per share without affecting the total
earnings and the amount of capital of the company.
0. Increa(e in Par !alue of S1are( +n exchange for the old shares a company may issue shares of
higher par value to its existing shareholders. .hile establishing parity between the par value and
the market value of the company-s shares this brings down the rate of dividend without affecting the
amount of dividend per share.
8. I((ue of Bonu( S1are( The most prevalent remedy to under'capitaliation is to capitalie the
retained earnings of the company by issuing bonus shares increasing the share capital as well as
the number of shares of the company. That, the rate of dividend per share comes down.
=. I((ue of S1are( an0 3e4enture( Under ? capitalied due to the inade"uacy of capital, company
may raise more capital by issuing shares and debentures. This increases the share capital and
number of shares of the company resulting in decline in the rate of dividend.
IMPAT OF O!E# APITALI%ATION
&ver ? capitaliation is harmful to the financial interests of the company as it adversely affects the financial
structure of the concern and the interests of shareholders and consumers. The share holders lose in terms
of capital and dividend. The employees are deprived of their fair compensation and stand to lose their $obs.
The consumers suffer in terms of reduced "uality and increased prices. The society finds that its resources
BSPATIL =D
are being misused. The remedies available to correct the situation of over'capitaliation are "uite painful.
The financial re'organiation of the company involves considerable sacrifice on the part of its shareholders.
+f the company goes into li"uidation the shareholders and creditors suffer a considerable loss.
IMPAT OF UN3E# APITALI%ATION
Under'capitaliation is undesirable business it accelerates, competition, breeds discontent among the
employees, accentuates the feeling of exploitation among consumers and tempts the management to enter
into speculation of the company-s shares. !owever, under'capitaliation also possesses some welcome
features. The shareholders and the society en$oy the prosperity of an under'capitalied company. 7ven the
employees and the consumers gain from the increased efficiency of the company. +t is easier to remedy
under'capitaliation by capitaliing the company-s surpluses.
&ver 4apitaliation Under'capitaliation
1. +mpact on #hareholders a. ) lower rate of return
b. Uncertain and irregular
income
c. 4apital value of the shares
is reduced
d. #peculation in shares
a. !igh rate of earning per
share
b. 4apital value of the share
is increased
c. .ide fluctuations in
market value of such
shares
0. +mpact on 4ompany a. The credit worthiness of
such company is reduced
b. Aaintenance, renewals
and replacement
programmes are
suspended
c. Boss of goodwill
manipulation to account
etc.
d. Aorale of the
management employees
is low
a. +t induces the
management to build up
secret reserves and
under'state earnings
b. The high rate of earnings
per share may increase
competition
c. The employees demand
high share in the
increased profits of the
company
8. +mpact on #ociety a. The "uality of the product
is effected
b. +n the long'run such
concerns are li"uidated
c. Boss of employment as
well as production
capacity.
a. The consumers are not
benefited even in this
state. Aanagement builds
up the reserve, etc.
b. The government can
charge excess profit'tax
from such companies.
#EME3IES LEA3IN. UN3E#7APITALI%ATION TO O!E# APITALI%ATION
1. Increa(e in profit( an0 Boo, )alue Under'capitaliation is characteried by an exceedingly high
rate of profit en$oyed by a corporation in relation to other similar firms in the industry. The entire
BSPATIL =G
profits of the company are not distributed among its shareholders as dividend, but a large part of its
profits are retained in the business in the form of reserves and surpluses. Thus, a large part of
profits is accumulated with the company, which forms a part of its capitaliation. )s profits of a
company belong to shareholders, the retained earning in the form of reserves and surpluses
constitutes a part of the company-s capitaliation, and the book value of the company is arrived at
by adding this amount to the capital of the company. ,etained earnings being a fixed liability of the
company, the book value of its assets exceeds by their real value in the market which is the state of
over'capitaliation. Thus, in due course under'capitaliation leads to over capitaliation.
0. 3ecrea(e in (1are capital an0 0i)i0en0 )s under ? capitalied company has lesser amount of
were capital and it has to depend on long'term borrowing for its expansion development
programmes, due to increased amount of risk to the creditors, the company has to pay higher rates
of interest, which leads to reduction of its profits. Thus the company fails to pay dividends at
generally prevalent rates. Due to lower dividend rate, the market value of the company-s shares
comes down. The real value of its assets is reduced to below their book value. thus, the company
becomes over'capitalied. Thus, Under capitaliation leads to over'capitaliation in due course of
time. The practice of under'capitaliation results in marking a concern over'capitalied.
MEANIN. OF -ATE#E3 APITAL
.hen the real value of its assets is less than its paid'up share capital, a part of the capital is not
represented by its assets, and the company-s capital is termed as >water capital- as worthless as a >water-.
)ccording to !oagland, E) stock is said to be watered when its true value is less than its book valueF.
Thus, a company-s capital is >watered- when the total amount of its paid'up share capital is not represented
by the same value of its asset. .atered capital means that the realiable value of the company-s assets is
less than its paid'up share capital.
AUSES OF -ATE#E3 APITAL
%ollowing are the causes of .atered 4apital
1. Purc1a(e or Tran(fer of A((et( at Inflate0 Price )s a company purchases or transfers assets
from a going concern at inflated prices, its capital becomes watered to the extent of the excess
price paid for the assets making the book value of assets more than their realiable or market
value.
0. In)e(tment in Intangi4le A((et( +f huge investments are made in ac"uiring intangible assets
such as goodwill, parents, copyright, trademarks, etc., at the time of promotion, and later on they
prove worthless or lose their utility for the company, its capital becomes watered as the real value
of the intangible assets is less than their book value.
8. O)er )aluation of Promoter( Ser)ice( The capital of the company becomes watered if the
services of the promoters are valued at a very high price and paid for by issuing them fully paid'up
shares of that amount.
=. 3efecti)e 3epreciation Polic9 Defective depreciation policy may contribute in making the
company-s capital watered. +t makes the book value of the assets bigger than their market value
due to inade"uate provision for wear and tear, depreciation and other losses.
3. Unfore(een 1ange( or Acci0ent( .atered capital occurs due to result of unforeseen internal
or internal changes or accidents such as fall in the real of shares due to decline in profits,
BSPATIL =1
inflationary condition etc.
ONT#OL OF -ATE#E3 APITAL
+rrespective of the causes of watered capital, it is always unproductive and it does not command any
earnings capacity. )s watered capital adversely affect the company, the management should take
following stern steps to correct it*
1. Ploug1ing Bac, or Profit( .atered capital may be corrected by ploughing back a substantial
part of the company-s profits for some years correcting the difference between the realiable value
and book value of the company-s assets.
0. A0e<uate pro)i(ion for 0epreciation The watered capital will come down and finally eliminated,
if the value of fixed asset is gradually reduced to the extent of their depreciation.
8. 3e7capitali(ation +f the par value of the shares held by the existing shareholders is reduced, the
deficiency of capital may be written off by the resultant capital gain.
-ATE#E3 STO8
.hen stock is not represented by assets of e"uivalent value, it is designated as >.atered stock- signifying
dilution of water in the capital of the enterprise. Aore often than not, services of promoters are valued
highly and are accordingly paid usually in the form of stocks. Under these circumstances, existence of
water in the stock cannot be ignored nevertheless the earning capacity of the enterprise may $ustify the
payment at exorbitant price. #imilarly when an enterprise pays higher price to the vendors for the assets
transferred, the enterprise will be in the state of watered stock.
#o as to test the existence of water in stock, the analyst should study the intent of the promoters who float
the enterprise and sell the stocks. +f the promoters deliberately ac"uire the assets needed by the enterprise
at inflated price, state of watered stock is said to have existed.
-ATE#E3 STO8S !S/ O!E#7APITALI%ATION
#ometimes the term .atered #tock is confused with overcapitaliation. !owever, there is a clear'cut
difference between the two. .hile the state of watered stock relates to promotion of an enterprise, a
company gets over'capitalied only when it fails to earn sufficient income to $ustify its capital. thus, at the
time of promotion, an enterprise is expected to ac"uire the assets at a price which represent their real
worth. +n case the assets ac"uire prove worthless or they have been bought at an inflated price, stock of
the enterprise will become watered stock. +n contrast, when an enterprise has run for several years and
during all these years it has not been able to make sufficient earnings to $ustify its capital, the enterprise
will be in the state of over'capitaliation. +t is important to note that state of watered stock may become
potent cause for the existence of over'capitaliation in the enterprise.
The above distinction can be made more clear with the help of the following example*
The 6ood Buck 4ompany issues 322 shares of ,s. 022H' each. +ssues are fully subscribed. This sum ;,s.
1,22,222< is utilied to ac"uire fixed assets for the corporation. )t the time of promotion of the enterprise, it
is discovered that realiable value of assets is ,s. G2,222. +t means that the stock of the company has
been watered to the time of ,s. 02,222. !owever, the company has run successfully for the past five years
and has, on an average, earned ,s. 13,222 yearly. +f earnings are being capitalied at 3M rate, the
capitalied value of earning will be ,s. 8,22,222, it suggests that the company having watered stock is not
over'capitalied. &n the other hand, the company may receive the assets of full value of ,s. 1,22,222 but it
BSPATIL 32
makes an average earnings of ,s. =,222 which is being capitalied at 3M rate giving capitalied value of
earnings e"ual to ,s. G2,222. +t means that although the company has no water in stock, it is over'
capitalied. Thus, watered stock is concerned with the realiable value of the assets which can be had by
li"uidating the assets in market, whereas over and under'capitaliation are relative terms which are related
with real value of assets determined by the actual earnings capacity of the company.
BSPATIL 31
UNIT !
APITAL ST#UTU#E
MEANIN. OF APITAL ST#UTU#E
4apital structure of a company cannot be the composition of long'term sources of long'term sources of
funds, such as ordinary shares, preference shares, debentures, bonds, long'term funds. +t implies the
determination of form or make'up of a company-s capitaliation.
3EFINITIONS OF EAPITAL ST#UTU#E@
1. E4apital structure is the permanent financing of the firm, represented primarily by long'term debt,
preferred stock, and common e"uity, but excluding all short'term credit. 4ommon e"uity includes
common stock, capital surplus and accumulated retained earnings.F
' .eston and Brigham
0. EThe term capital structure is fre"uently used to indicate the long'term sources of funds employed in
a business enterpriseF.
' ,obert !. .essel
8. E%rom a strictly financial point of view, the optimum capital structure is achieved by balancing the
financing so as to achieve the lowest average cost of long term funds. This, in, turn produces the
maximum market value of the total securities issued against a given amount of corporate incomeF.
' 6uthman and Dougall
=. E4apitaliation embraces the composition or the character of the structure as well as the amountF
' !usband and Dockeray
3. E4apital structure refers to the kind of securities that make up the capitaliation.F
' .. 6erstenberg
C. EThe term capital structure is fre"uently used to indicate the long'term sources of funds employed in
a business enterpriseF.
' ,.!. .essel
D. E4apital structure is the combination of debt and e"uity securities that comprise a firm-s financing of
its assetsF.
' John J. !ampton
3ISTINTIONS BET-EEN APITALI%ATION AN3 APITAL ST#UTU#E
1. 3ifference in (cope 4apitaliation refers to the total accounting value of all the capital regularly
employed in the business, which includes share capital, long'term debt, reserves and surplus. &n
the other hand capital structure refers to the proportion of different sources of long'term funds in the
capitaliation of a company.
0. 3ifference in o4?ecti)e( 4apitaliation is concerned with the determination of the total amount of
capital re"uired for the successful business operation, on the other hand capital structure is
concerned with the determination of the composition of different long'term sources of funds, such
BSPATIL 30
as debentures, long'term debt, preference capital and ordinary share capital including retained
earnings.
+n order to maximie the shareholder-s wealth, the financial manager should attempt to achieve an optimal
capital structure which refers to an ideal combination of various sources of long'term funds so as to
minimie the overall cost of capital and maximie the market value per share. The optimum capital could
be achieved when the marginal cost of each source of finance is the same. +t is incorrect to say that there
exists an ideal mix of debt and e"uity capital which will produce an optimum capital structure leading to the
maximiation of market price per share. There is no single optimal capital structure for all firms, or for the
same firm for all times. The financial manager should attempt to develop an appropriate capital structure
for his firm instead of trying for un utopian >optimal capital structure-.
"A#ATE#ISTIS OF OPTIMAL ST#UTU#E
%ollowing are the characteristics of an optimal of capital structure.
1. Simplicit9 ) sound capital structure is simple in the initial stage are which limits to the of the
number of issues and types of securities. +f the capital structure is complicated from the very
beginning by issuing different types of securities, the investors hesitate to invest is such a company.
The company may also face difficulties in raising additional capital in future. That it is advisable to
issue e"uity and preference shares in developing an optimum capital structure. Debentures and
bonds should be reserved for futures financial re"uirements.
0. Minimum o(t ) sound capital structure attempts to establish the security'mix in such a way as
to raise the re"uisite funds at the lowest possible cost. )s the cost of various sources of capital is
not e"ual in all circumstances it is ascertained on the basis of weighted average cost of capital. The
management aims at keeping the expenses of issue and fixed annual payments at a minimum in
order to maximie the return to e"uity shareholders.
8. Ma>imum #eturn ) balanced capital structure is devised in such a way so as to maximie the
profits of the corporation through a proper policy of trading on e"uity so as to minimie the cost of
capital.
=. Minimum #i(, )n ideal capital structure possesses the "uality of minimum risk. ,isks, such as
increase in taxes, rates of interest, costs, etc., and decrease in prices and value of shares as well
as natural calamities adversely affect the company-s earning. Therefore, the capital structure
devised in such a way as to enable it to afford the burden of these risks easily.
3. Ma>imum ontrol ) sound capital structure retains the ultimate control of a company with the
e"uality shareholders who have the right to elect directors. Due consideration is given to the
"uestion of control in management while deciding the issue of securities. The existing shareholders
may not be able to retain control. +f a large number of e"uity share are issued, the company issues
preference shares or debentures instead of e"uity shares to the public because preference shares
carry limited voting rights and debentures do not have any voting rights. The capital structure of a
company is changed in such a way which would favorably affect the voting structure of the existing
shareholders and increase their control on the company-s affairs.
C. Fle>i4le ) flexible capital structure enables the company to make the necessary changes in it
according to the changing conditions and make it possible to procure more capital whenever
re"uired or redeem the surplus capital.
D. Li<ui0 +n order to achieve proper li"uidity for the solvency of a corporation, all such debts are
avoided which threaten the solvency of the company. ) proper balance between fixed assets and
current assets is maintained according to the nature and sie of business.
BSPATIL 38
G. on(er)ati)e +n division of the capital structure a company follows the policy of conservation. +t
helps in maintaining the debt capacity of the company even in unfavourable circumstances.
1. Balance0 apital ) balance is necessary for the optimum capital structure of a company. )s
both, under capitaliation and over'capitaliation are in$urious to the financial interests of a
company, there is a proper co'ordination between the "uantum of capital and the financial needs of
the corporation. ) fair capitaliation enables a company to make full utiliation of the available
capital at minimum cost.
12. Balance Le)erage 7 ) sound capital structure attempts to secure a balanced leverage by issuing
both types of securities i.e., ownership securities and creditor ship securities. #hares are issued
when the rate of capitaliation is high, while debentures are issued when rate of interest is low.
IMPO#TANE OF SOUN3 APITAL ST#UTU#E
1. MinimiAe0 o(t The primary ob$ective of a company is to maximie the shareholder-s wealth
through minimiation of cost. ) well'advised capital structure enables a company to raise the
re"uisite funds from various sources at the lowest possible cost in terms of market rate of interest,
earning rate expected by prospective investors, expense of issue etc. this maximie the return to
the e"uity shareholders as well as the market value of shares held by them.
0. Ma>imiAe0 #eturn The primary ob$ective of every corporation is to promote the shareholders
interest. ) balanced capital structure enables company to provide maximum return to the e"uity
shareholders of the company by raising the re"uesting capital funds at the minimum cost.
8. MinimiAe #i(,( ) sound capital structure serves as an insurance against various business risks,
such as interest in costs, interest rates, taxes and reduction in prices. These risks are minimied by
making suitable ad$ustments in the components of capital structure. ) balanced capital structure
enables the company to meet the business risks by employing its retained earning for the smooth
business operations.
=. ontrolle0 Though the management of a company is apparently in the hands of the directors,
indirectly, a company is controlled by e"uity shareholders carry limited voting rights and debentures
holders do not have any voting right, a well'devised capital structure ensures the retention of
control over the affairs of the company with in the hands of the existing e"uity shareholders by
maintaining a proper balance between voting right and non'moving right capital.
3. Li<ui0 7 )n ob$ect of a balanced capital structure is to maintain proper li"uidity which is necessary
for the solvency of the company. ) sound capital structure enables a company to maintain a proper
balance between fixed and li"uid assets and avoid the various financial and managerial difficulties.
C. Optimum UtiliAation &ptimum utiliation of the available financial resources is an important
ob$ective of a balanced financial structure. )n ideal financial structure enables the company to
make full utiliation of available capital by establishing a proper co'ordination between the "uantum
of capital and the financial re"uirements of the business. ) balanced capital structure helps a
company to estimate both the states of overcapitaliation and under'capitaliation which are
harmful to financial interests of the company.
D. Simple ) balanced capital structure is aimed at limiting the number of issues and types of
securities, thus, making the capital structure as simple as possible.
G. Fle>i4le %lexibility or capital structure enables the company to raise additional capital at the time
of need, or redeem the surplus capital. it not only helps is fuller utiliation of the available capital but
also eliminates the two undesirable states of over'capitaliation and under ? capitaliation.
BSPATIL 3=
FATO#S 3ETE#MININ. APITAL ST#UTU#E
The factors determining capital structure of a company may be internal or external.
A/ INTE#NAL FATO#S
1. Nature of Bu(ine(( 4ompanies have stable earnings can afford to raise funds through sources
involving fixed charges, while other companies have to rely heavily in e"uity share capital. (ublic
utilities, extractive, financing and merchandising enterprises are more stable in their earnings and
en$oy greater degree of freedom form competition than industrial concerns.
0. #egularit9 of Income 4apital structure is affected by the regularity of income. +f a company
expects regular income in future, debenture and bonds should be issued. (reference shares may
be issued if a company does not expect regular income but it is hopeful that its average earnings
for a few years may be e"ual to or in excess of the amount of dividend to be paid on such
preference shares.
8. ertaint9 of Income +f a company is not certain about any regular income in future, it should
never issue any type of securities other than e"uity shares.
=. 3e(ire to control t1e Bu(ine(( +f the control of the company is to be retained within few hands,
a large proportion of funds is raised by issuance of non'voting right securities, such as debentures
and preference shares. ) ma$ority of voting right securities, i.e. e"uity shares are held by the
promoters or their relatives to control the affairs of the business. Thus, ma$ority of funds are raised
from public retaining the control of the company with the promoters or the existing shareholders.
3. 3e)elopment an0 E>pan(ion Plan( 4apital structure of a company is affected by its
development and expansion progremmes in future. The amount of authoried capital is kept higher
so that the re"uisite amount may be raised at the time of need. +n the beginning the company
collects capital by issuing shares. Therefore, capital structure is devised in accordance with the
future development and expansion programmes. The re"uisite capital is raised through preference
shares and debentures.
C. Purpo(e of Finance )n important factor determining the type of capital to be raised is the
purpose for which it is re"uired. +f funds are needed for some product give activity directly adding to
the profitability of the company, capital may be raised by issuing securities bearing fixed charges
like preference shares and debentures. &n the other hand, if funds are needed for such purposes
as betterment, maintenance, etc. which do not directly add to the earnings of the company retained
earnings, e"uity share capital will be the better source of financing.
D. 1aracteri(tic of Management Karying in skill, $udgement, experience, temperament and
motivation management evaluates the same risks differently and its willingness to employ debt
capital also differ. Thus capital structure is influenced by the age, experience, ambition, confidence,
conservativeness and attitude of the management.
G. Tra0ing on E<uit9 Trading on e"uity means the regular use of borrowed capital as well as e"uity
capital in the conduct of a companies business. +f a company employ borrowed capital including
preference share capital to increase the rate of return on e"uity shares, it is said to be trading on
e"uity. +f the fixed rate of interest on borrowed capital or dividend on preference shares is lower
than the general rate of earnings of the company, the e"uity shareholders will have an advantage in
the form of additional dividend. Trading on e"uity implies the presence of a favourable financial
leverage in the company-s capital structure. ) company would prefer to issue debentures or
BSPATIL 33
preference shares having a rate of interest or dividend lower than the general rate of its earnings.
1. 3e4t capacit9 an0 #i(, )fter a certain extent the use of borrowed capital become risky for the
company because it leads to increase in the fixed liability of interest payment adversely affecting
the company-s income and reducing its li"uidity. 7xcessive use of borrowed funds endangers the
solvency of the company in the long run. !igh debt e"uity ratio is particularly risky for the
companies with uncertain, irregular and inade"uate earnings. The determination of debt e"uity ratio
of such companies should be in accordance with their debt capacity.
12. o(t of apital 4ost of capital is an important determinant of capital structure of a company. +t
influences the profitability and general rate of earnings. ) company must raise capital funds by
borrowing when rate of interest is low, and by issuing e"uity shares when rate of earnings and
share prices are high.
11. apital .earing #atio The ratio of e"uity share capital to the total capital is called >4apital
6earing-. .hen the ratio of e"uity shares is low in the total capital structure, is called >!igh
6earing-. &n the contrary when the ratio of e"uity shares in the total capital structure of a company
is high, it is called >Bow 6earing-. #tability in e"uity price and goodwill of a company depends on
ade"uate capital gearing. ) high capital gearing ratio encourages speculation in shares of such a
company and market price of shares continuous to fluctuate. Therefore, it is necessary for the
promoters to determine the ratio of fixed cost securities ;preference shares and debentures< and
fluctuating cost securities ;e"uity shares< very carefully.
10. Fle>i4ilit9 The capital structure must have flexibility as to increase or decrease the funds as per
re"uirements of the enterprise. 7xcessive dependence on fixed cost securities make the capital
structure rigid due to fixed payment of interest or dividend. These sources should be kept in reserve
for emergency and expansion purpose.
18. Simplicit9 The capital structure must have simplicity, so that financial crises may be avoided.
B/ E>ternal Factor(
1. Ta(te( an0 Preference of In)e(tor( )n ideal capital structure is one which suits the needs
of different types of customers. +ts success largely depends upon the psychological conditions
of different types of investors. .hile some investors prefer security of investment and stability of
income others prefer higher income and capital appreciation. !ence, shares and debentures
should be issued in accordance with the tastes and preferences of all types of customers. To
suit the financial status of various sections of the society, a company should issues different
types of securities with different denominations.
0. on0ition( of apital Mar,et 4onditions of capital market have a direct bearing on the
capital structure. +n times of depression the possibilities of profit are the least and rate of
dividend on e"uity shares comes down. !ence the investors would prefer to invest in
debentures and not in e"uity shares. Therefore debentures should be issued in times of
depression. &n the contrary, any type of security can be issued to raise the re"uisite funds
during boom period when people have sufficient funds. Therefore, e"uity shares should be
issued during boom period.
8. o(t of apital )s the cost of capital issue affects the capital structure of a company. The
capital structure should be designed to minimie the commission payable to brokers,
middlemen and underwriters or the discount payable on issue of debentures and bonds. )
company should raise funds by issuing different types of securities in such a way as would
minimie the cost of capital issue.
BSPATIL 3C
=. Pre(ent Statute( an0 #ule( 4apital structure a influenced by the statures and rules
prevailing in the country. +n +ndia, Banking 4ompanies act restricts a banking company from
issuing any type of securities other than e"uity shares. 4ontrol of capital issues )ct has fixed = *
1 ratio for debt and e"uity and 8*1 ratio for e"uity and preference share capital.
3. Po((i4le 1ange( in La: Besides complying the legal restrictions, a company-s capital
structure is also influenced by the possible changes in the law of the country. %or example, if a
company-s income is taxed at a higher rate then the directors should issue debentures because
the amount of interest payable to debentures holder is deducted while computing the company-s
total income. .hereas it is a statutory deduction, dividends are not an accepted deduction.
ONEPT OF BALANE3 APITAL ST#UTU#E
4apital structure or financial plan refers to the composition of long'term sources of funds as debentures,
long'term debts, preference and ordinary share capital and retained earnings ;reserves and surpluses<.
4ompanies that do not plan their capital structure may prosper in the short run, but ultimately they face
serious problems in raising funds to finance their activities. Therefore, it is important for a company to take
a decision regarding its capital structure. .henever financial manger considers the "uestion of capital
structure, it is always the "uestion of optimum or balanced capital structure i.e., to decide the proportion of
ownership funds and borrowed funds. &wnership funds include ordinary and performance share capital
and retained earnings ;reserves and surplus< while borrowed funds include the amount raised by the issue
of debentures, and loans taken from the financial institutions.
&ptimum or balanced capital structures means an ideal combination of borrowed and owned capital that
may attain the marginal goal i.e. maximiing of market value per share of minimiation of cost of capital.
the market value is maximied or the cost of capital is minimied when the real cost of each source of
funds is the same. +t is the task of the financial manages to determine the combination of the various
sources of long'term finance.
"A#ATE#ISTIS OF A BALANE3 APITAL ST#UTU#E
) sound capital structure should be devised keeping in view the interests of the ordinary shareholders,
employees, customers, creditors etc. ) sound capital structure should possess the following
characteristics.
1. Profita4le The capital structure should be devised in such a way as to maximie the profits of the
company keeping in views the burden of the cost of capital on the income of the firm. +n order to
achieve this ob$ective, a proper policy of trading on e"uity should be followed.
0. Sol)ent Due consideration should be given to the solvency of the company. +f a debt threatens
the solvency of the company, it should be avoided.
8. Fle>i4le The capital structure of a company should be flexible enough to suit the changed
conditions. The company should not feel any difficulty in raising funds when they are re"uired or in
redeeming them when they are not re"uired nay more. 7"uity shares score over preference shares
because there is greater liberty in the payment of dividends on e"uity shares. #imilarly preference
shares are preferred to debenture as non'payment of interest on debentures. Bikewise, debentures
can be reduced at any time even before maturity under terms of issue. The redemption of
preference shares does not affect the nature but composition. The ordinary shares cannot be
redeemed except under the scheme of re'organiation. 4onsidering this fact, the capital structure
should be as flexible as possible.
=. on(er)ati)e ) company should follow the policy of conservation while devising its capital
structure in the sense that the debts capacity of the company should not be disturbed. The
BSPATIL 3D
management should bear in mind the various factors and their effects on its creditability such as
value of other securities, issue of securities in future maintenance of profits, burden of taxes and
future rearrangement of capital structure etc. such capital structure offers certain decisive
advantages to the company, namely, ;i< the company-s cost of capital is the least@ ;ii< its prospects
of raising capital are good in future even in unfavorable times@ and ;iii< it can be successful in
maintain healthy relations with security holders. This policy favors for the maintenance of ,eserve
and surplus at a fairly high figure in a bid to provide guarantee to contributors of funs towards debt
paying capacity of the company.
3. ontrolle0 #ound capital structure provides maximum control of the e"uity shareholders on the
company-s affairs.
C. Simplicit9 ) sound capital structure defines clearly the rights attached to each type of securities.
+t is easy type of securities. +t is easy to manage.
D. Economic 4apital mix entails the minimum cost of issue of securities and cost of financing etc.
G. Attracti)e #ecurities proposed to be issued offer certain attractions to the investors either in
relation to income, control or overtability.
1. Balance0 in Le)erage Both types of securities i.e., ownership and creditor ship, are issued to
secure a balanced leverage. 5ormally, debentures are issued when rate of interest is low and
shares when rate of capitaliation is higher.
OBJETI!ES OF BALANE3 APITAL ST#UTU#E
+n devising a sound or balanced capital structure, the manager should bear in mind the following
ob$ectives.
A/ EONOMI OBJETI!ES
1. Minimum o(t( 4entral cost of various sources of funds are not e"ual in all circumstances. &ne
of the ma$or ob$ectives of a business enterprise is to raise funds at the lowest possible cost in a
given set of circumstances in terms of interest, dividend and the relationship of earnings to the
prices of shares. The management should aim at keeping the cost of issue at a minimum to
maximum the returns to e"uity shareholders.
0. Minimum #i(,( Karious risks are involved in business operations which have direct bearings on
the capital structure of the company such as business risk, management risks, tax risk, trade cycle
risks, purchasing power risks, interest rate risk etc. These risks should be minimied by making
suitable ad$ustments in the components of capital structure.
8. Ma>imum #eturn &n of the ob$ectives of balanced capital structure is to provide for the
maximum return to the real owners ;e"uity shareholders< of the company. +t may be achieved by
minimiing the cost of issue and the cost of financing.
=. Pre(er)ation of ontrol of E<uit9 S1are1ol0er( 6enerally e"uity shareholders have the
control over the affairs of the company. (reference shareholders and the debenture holders have
limited voting rights in matters affecting their interests. The capital structure should be designed as
to preserve the control of e"uity shareholders and to prevent the erosion of control from their
hands. +t re"uires proper balance between voting right and non'voting right capital.
3. Proper Li<ui0it9 Bi"uidity is necessary for the solvency of the company. ) proper balance
between fixed assets and the li"uid assets should be maintained. 5ature and sie of the business
BSPATIL 3G
decide the ideal ratio of fixed and li"uid assets.
C. Fuller UtiliAation There must be proper co'ordination between the "uantum of capital and the
financial re"uirements of the business so that full utiliation of available capital may be made at
minimum cost. Both the states of under ? capitaliation and unwarranted to the health of industry.
%uller utiliation of capital is also not possible in case of watered capital. %ull utiliation of capital
re"uires a fair capitaliation.
B/ OT"E# OBJETI!ES
1. Simplicit9 The capital structure should be as simple and conservative as possible. +n the
beginning a company should raise only the ownership capital i.e., e"uity share capital that will
enhance the credit of the company. ) preference issue may be made if, warranted by the
circumstances.
0. Fle>i4ilit9 The management should design the capital structure in order to make necessary
changes in it whenever re"uired. Aanagement should en$oy the maximum freedom of action to
manage the income and capital of the firm.
BSPATIL 31
UNIT !I
SOU#ES OF FINANE I
O#PO#ATE S"A#E APITAL
) company needs finance to meet its various types of re"uirements. .hile some fund are re"uired for a
fairly long time for the purpose of ac"uiring fixed assets, some other are re"uired for day today working.
The method of raising funds is decided after taking into consideration the period for which funds are
re"uired. Bong'term funds are raised in such way that a company may have uninterrupted use of it for a
sufficiently long time. +t is unwise for a company to take loans from a bank to ac"uire a fixed asset as loan
as it is a source of obtaining funds only for a short period.
#ource fork funds for a company may be classified into two broad categories according to he mode of
raising funds ;1< By issue of securities such as shares ;e"uity and preference< and debentures and ;0< By
other methods such as financial institutions etc. )ccording to the +ndian 4ompanies )ct 113C, a company
can issue two types of securities ;1< ownership securities, and ;0< creditor ship securities. The ownership
securities include the e"uity and the performance shares, while creditor'ship securities include debentures
and bends.
1. O:ner(1ip Securitie( These may be classified into ;i< e"uity shares and ;ii< preference shares.
;i< E<uit9 S1are( These are the shares the holders of which are the residual climates and
have no preference in capital as well a in the income of the company. They provide the Erisk
capitalF or Eventure capitalF of the company. They control the affair of the company and carry
with them the ownership responsibilities.
;ii< Preference (1are( #ection G3;+< of the 4ompanies )ct, has defined preference shares as
those which carry preferential rights about the payment of dividend at a fixed rate either
free of or sub$ect to income tax, and about the repayment of capital. these shareholders
en$oy two preferential rights over the other category of shares. %irstly, they are entailed to
receive a fixed rate of dividend out of the net profits of the company prior to declaration of
dividend on e"uity shares. #econdly, after the payment of debts of the company under
li"uidation, the remaining assets are first appropriate for returning the capital contributed by
the preference shareholders.
*/ re0itor(1ip Securitie(
;i< 3e4enture( ) debenture is an acknowledgement of debt by a company under its seal.
Debentures are e"ual parts of a loan raised by a company, offered to the public through
prospectus. Debentures always secured either by floating charge or by fixed charge.
;ii< Bon0( Bond is an agreement between bond holders and the company, called bond'indenture
containing the terms and conditions. )ppointed by the company, a trustee acts as an agent of
the bondholders. Bonds may be classified as secured and unsecured, redeemable and
irredeemable bonds etc. ) big ma$ority of bonds carry a fixed rate interest.
SI.NIFIANE OF SEU#ITIES IN FINANIAL ST#UTU#ES
%ollowing is the significance of securities in the financial structure of a company*
1. Bonds or debentures are issued only when the future earnings of company are liberal and fairly
consent. ) public utility concern may collect a fairly large amount through debentures as its earning
are somewhat constant.
0. 7"uity shares are issued and debt is contracted in the beginning by basic and manufacturing
BSPATIL C2
industries.
8. &nly e"uity shares are issued when fresh capital re"uired by an existing concern whose previous
earnings have been unstable.
=. 4heap borrowed funds are used for expansion purposes, when a company has become well
established and the earning have stabilied. .hen debentures are issued to obtain these funds, it
is twice the interest charges being carried by the public utility concerns and four times by other
concern.
3. +f funds are obtained on the basis of mortgage issue, the total amount thus collected does not
exceed half the depreciated value of the assets covered by the mortgage.
C. +ndustrial having large assets may issue irredeemable debenture or long'term redeemable
debentures.
D. .hen the earnings are irregular but average profits over a period of years give a fair margin over
preference shares, dividend preference shares may be issued.
MEANIN. OF S"A#E APITAL
#hare capital is the capital raised by a company through the issue of shares. +t constitutes the basis of the
capital structure of a company. &nly companies limited by shares and registered with a share capital can
raise capital through the issue of shares. #hare capital may be raised either at the time of formation of the
company for starting business operations or, later on for future expansion of the business. )uthoried
capital is the sum mentioned in the Aemorandum of )ssociation as he capital of the company. +t is the
maximum amount of capital which the company is authoried to raise by the issue of shares. +ssued capital
is the part of the authoried capital which is issued for public subscription for the time being.
MEANIN. OF S"A#E
1. E#hare means share in the share capital of company and includes stock where a distinction
between stock and shares is expressed or impliedF.
'#ection 0 of the +ndian 4ompanies )ct 113C
0. E) share is that proportionate part of capital to which a member is entitledF.
' Bord Justice James Bindley
The total capital of the company is divided into a large number of shares to facilitate public subscription to
the capital in smaller amount. %or example if the capital of a company is ,s. 02,22,222, it can be divided
into 022,222 shares of ,s. 12H' each. Thus share is one of the e"ual parts into which the capital of a
company is divided entitling the holder of the share to a proportion of the profits.
8IN3S OF S"A#ES
)ccording to the +ndian 4ompanies )ct 113C, following are two types of shars*
;i< 7"uity #hares
;ii< (reference #hares
;i< E<uit9 S1are( 7"uity means the ownership interest or the interest of shareholders as
measured by capital and reserves. )ccording to the +ndian 4ompanies )ct 113C e"uity shares
are those ownership securities which do not carry any special or preferential rights in respect of
dividend or return of capital. e"uity shareholders are the owners and risk'bearers of the
company. )n e"uity shares is distinguished by the following characteristics.
BSPATIL C1
a. No fi>e0 rate of 0i)i0en0 Dividends in respect of e"uity shares are paid only after the
preference shareholders have been paid the dividends due to them.
b. Pa9ment after 3e4t/ #epa9ment +n the case of winding up of the company, an e"uity
shareholder will be paid back his capital only after all other debts, including the preference
share capital, has been repaid in full.
c. #ig1t to !ote The e"uity shareholders is entitled to the rights to vote at the annual
general meetings of the company. !e participates in the management and control of the
company. The right is not available to the preference shareholder except in special
circumstances.
;ii< Preference S1are( )ccording to +ndian 4ompanies )ct 113C E) preference share is a share
which carries a preferential right both as regards to a fixed dividend and as regards to the
payment of capital in winding'upF.
The preference shares have the following characteristics
1. There is a fixed rate of dividend to them.
0. They get priority over e"uity shareholders in respect of payment of dividend.
8. They are paid back their capital ahead of e"uity shareholders in the event of the company-s
li"uidations.
=. They do not have any voting rights except in some special circumstances.
3. (reference shares stand mid'way between debentures and e"uity shares. Bike debentures
they get a fixed dividend and en$oy priority over e"uity shareholders in the payment of
dividend as also return of capital return of capital in the case of winding up. Bike debentures
they do not en$oy any voting rights. &n the other hand, like e"uity shares they participate in
the residual profits of the company.
C. (reference shareholders are paid dividend, not interest, though dividend on such shares is
paid at fixed rate.
D. There is no legal obligation to pay dividend on such shares year after year. +f the company
does not have enough profits in any year it can avoid payment of dividend on preferences
shares without inviting any legal action.
T=PES OF P#EFE#ENE S"A#ES
) according to the rights attached to them the preference share may be of the following types*
1. 4umulative and 5on'4umulative (reference #hares
0. (articipating and 5on'(articipating (reference #hares
8. ,edeemable and +rredeemable (reference #hares
=. 4onvertible and 5on'convertible (reference #hares
3. 6uaranteed (reference #hares.
1. umulati)e an0 Non7umulati)e Preference S1are( ? The holders of cumulative preference
shares are entitled to arrears of dividend on their shares to be paid out of the profits of subse"uent
years, if the dividend on them cannot be paid in any year. They are sure to receive dividend on the
BSPATIL C0
preference shares held by them for all the years out of the earnings of the company. +f they are not
paid the dividend in a particular year, they are paid such arrear in the next year before any dividend
can be distributed among e"uity shareholders but if dividend is not paid in any year the dividend on
non'cumulative shares does not accumulate.
0. Participating an0 Non7Participating Preference S1are( The holders of participating preference
shares are entitled to a shares in the surplus profits after paying dividend to preference shares and
e"uity shares. Thus, participating shareholders obtain return on their investment in two forms fixed
dividend and shares in surplus profits. 5on'participating preference shares are those preference
shares which do not carry the right to share in the surplus profits.
8. #e0eema4le an0 Irre0eema4le Preference S1are( ,edeemable preference shares are those
which will be repaid on or after a certain date in accordance with the terms of their issues.
+rredeemable preference shares are those preference shares which cannot be redeemed during the
life time of the company.
=. on)erti4le an0 Non7on)erti4le Preference S1are( 4onvertible preference shares are those
preference shares which are given a right to be converted into e"uity shares within a fixed period of
time. 5on'convertible preference shares are the preference shares which cannot be converted into
e"uity shares.
3. .uarantee0 Preference S1are( These shares are issued when a company is converted from a
private limited to (ublic United company or when one company is sold to another company. The
seller or any other interested party guarantee the payment of dividend on preference shares of a
specific rate for a number of years.
ME#ITS OF P#EFE#ENES S"A#ES
1/ A3!ANTA.ES F#OM OMPAN= POINT OF !IE-
;i< Fi>e0 #eturn The dividend payable on preference share is usually fixed lower than that
payable on e"uity shares. This helps the company in maximiing the return to e"uity
shareholders.
;ii< No )oting #ig1t (reference shareholders have no voting right on matters not directly
affecting their rights, leaving e"uity shareholders ration uninterrupted control over the affairs
of the company.
;iii< Fle>i4ilit9 By issuing redeemable preference shares a company can maintain flexibility in
its capital structure as these can be redeemed under terms of issue.
;iv< No Bur0en on Finance Unlike debentures or bonds, preference shares do not prove a
burden on the finances of the company. Dividend on preference shares are paid only if
profits are available for it. Thus the company has a stronger balance sheet and hence
greater scope for future borrowing.
;v< No c1arge on A((et 5on ? payment of dividend on preference share does not create a
charge on the assets of the company. +t enables the company to conserve mortgage able
assets of the company. +t is therefore very useful if its assets are made available as
collateral security for borrowing on debentures.
;vi< -i0e apital Mar,et The issue of preference shares widens the scope of capital market
as they provide the safety as well as a fixed rate of return to the investors. The company will
BSPATIL C8
not be able to attract the capital from such moderate type of investors if it does not issue
preferences shares.
*/ A3!ANTA.ES F#OM IN!ESTO#@S POINT OF !IE-
;i< #egular Fi>e0 Income 7ven if there is no profit,. The investors get a fixed and regular rate of
dividend on preference shares. The dividend for the years in which company earned no profit or
inade"uate profits, may be paid in the year of profits.
;ii< Preferential #ig1t( +n case of winding up of company, preference shares carry preferential
rights as regards the payment of dividend and repayment of capital. thus they en$oy the
minimum risk.
;iii< !oting #ig1t for Safet9 of Intere(t +n matters directly affecting their interest preference
shareholders re given voting rights. Thus their interest is safeguarded.
;iv< Le((er apital Lo((e( )s the preference shareholders are given voting rights in saves them
from capital losses. Their interest is safeguarded.
;v< Fair Securit9 During depression period when the profits of the company goes down or when
the rate of interest in the market continuously falls down, preference shares are fair securities
for the shareholders.
1/ 3emerit( for in)e(tor(
;i< No )oting #ig1t The preference shareholders en$oy no voting right except in matters directly
affecting their interest. !ence, they do participate in policy decisions.
;ii< Fi>e0 Income 7ven if the company earns higher profit, the dividend on preference shares
other than participating preference shares is fixed.
;iii< No claim o)er Surplu( The preferential shareholders have no claim over the surplus. They
may only ask for the return of their capital investment in the preference shares of the company.
;iv< #e0emption ) company may redeem the redeemable preference shares at its option at any
time when it feels convenient to pay them off.
;v< No .uarantee of A((et( ) company provides no security to the preference capital as is
made in the case of debentures. Thus their interests are no protected by the assets of the
company.
EBUIT= S"A#ES
7"uity #hares are those which constitute working capital of a company. Dividend on these shares is not
fixed. +t is paid after the fixed rate of dividend on preference shares has been paid off. 7ven on dissolution,
they are residual climate. !owever, with voting right they control the affairs of the company.
1/ ME#ITS OF EBUIT= S"A#ES
;i< Long term an0 permanent apital 7"uity is a good sources of long'term finance. During
its life'time a company is not re"uired to pay'back the e"uity capital. Thus, it is a permanent
sources of capital.
;ii< No fi>e0 Bur0en 7"uity shares impose no fixed burden on the company resources, as the
dividend on these shares is sub$ect to availability of profits and the intention of the Board of
Directors. #hareholders may not get the dividend even if the company has profits. They may
get the dividend out of accumulated profits even if the company has earned no profit or
inade"uate profits for the current year. Thus e"uity shares provide a cushion of safety against
BSPATIL C=
unfavorable development.
;iii< re0it -ort1ine(( +nsurance of e"uity share capital cerates no charge on the assets of the
company. ) company may raise further finance on he security of its fixed assets. 7"uity capital
provides safety to the creditors.
;iv< #i(, apital 7"uity capital is the risk capital. ) company may trade on e"uity in bad periods.
+f the company earns lesser profits by trading on e"uity the e"uity shareholders would be the
real loser.
;v< 3i)i0en0 Polic9 ) company may follow an elastic and rational dividend policy creating huge
reserves for its development programmes.
*/ ME#ITS TO IN!ESTO#S
;i< More Income )fter meeting all the fixed commitments i.e. interest on debentures and
preference shares e"uity shareholders are the residual claimant of the profits. To add to its
profits the company generally trade on e"uity. +n boom period e"uity may get dividend at a
higher rate.
;ii< #ig1t to Participate in t1e ontrol an0 Management 7"uity shareholders have voting rights
on control over the affairs of the company. They elect competent persons as directors on the
Board of Directors to control and manage the affairs of the company.
;iii< apital Appreciation The market value of e"uity share fluctuates directly with the profits of
the company. Their real value is based on the net worth of the company-s assets. +t brings
capital appreciation in their investments. +f the profits of the company are accumulated, it will be
distributed among the shareholders as bonus shares, thus increasing the capital.
;iv< Attraction for Per(on( 1a)ing Limite0 Income )s e"uity are mostly of lower denomination,
persons of limited resources can purchase these shares. This widens the scope of
marketability-s of these shares.
;v< Pre7empti)e #ig1t +n any successive issue of shares of the company the e"uity shareholders
of a company have pre'emptive right in a certain proportion fixed by the Boards of Directors.
The e"uity shareholders may be benefited by such right issue, if the company is a prospecting
company.
;vi< Ot1er A0)antage( Their prices in security market are more fluctuating as it appeals most to
the speculators.
1/ 3EME#ITS OF EBUIT= S"A#ES
;i< 3ilution in ontrol 7ach sale of e"uity shares dilutes the voting power of the exiting e"uity
shareholders, as it extends the voting or controlling power to the new shareholders. )s e"uity
shares are transferable certain groups of e"uity shareholders may manipulate control and
management of company by controlling the ma$ority holdings which may be detrimental to the
interest of he company.
;ii< Tra0ing on E<uit9 not Po((i4le ) company cannot trade on e"uity if e"uity shares alone are
issued. Trading on e"uity is possible only when the other securities, bearing fixed rate of
dividendHinterest are issued and the dividend or interest payable such securities is less than the
profitability rate of company earnings.
;iii< O)er apitaliAation 7xcessive issue of e"uity shares may result in over'capitaliation which
makes dividend per share low which adversely affects the psychology of the investors.
BSPATIL C3
;iv< Infle>i4ilit9 of apital Structure 7"uity shares cannot be paid back during the life'time of the
company, it creates inflexibility in its capital structure. !igh costs more to with e"uity shares
than with other securities settling costs and underwriting commission are paid at a higher rate
on the is one of these shares.
;v< Speculation 7"uity shares of good companies are sub$ect to hectic speculation in the stock
market, making prices fluctuate fre"uently, which is not in the nearest of the company.
*/ 3EME#ITS TO OMPAN=
;i< Uncertain an0 Irregular Income The payment of dividend on e"uity share is sub$ect to the
availability of profits and the intention of the Board of Directors. )s the income of any
commercial organiation is not regular and certain, the e"uity shareholders may not get any
dividend if there is insufficient profit or if the management thinks it proper not to pay any
dividend on these hares even if there are sufficient profits.
;ii< apital Lo(( 3uring 3epre((ion Perio0 During depression period the profits of the
company and conse"uently the rate of dividend comes down due to which the market value of
e"uity shares goes down resulting in a capital loss to the investors.
;iii< Lo(( on Li<ui0ation 7"uity shareholders are the worst sufferers in case of li"uidation of the
company because they are paid in the last after every other claim including the claim of
preference share holders is settled.
S"A#E
1. E#hareF is E#hareF in the share capital of a company and includes stock, except where a distinction
between stock and share is expressed or impliedF.
' Section *&5D' of t1e In0ian ompanie( Act 1F6D

0. ) share may be defined as Ethe interest of a shareholder in the company measured by a sum of
money, for the purpose of liability in the first place and of interest in the second, and also consists
of a series of mutual convenient entered into by all the shareholders inter'se in accordance with the
provisions of companies act and )rticles of association.
' Ju(tice Far:ell
STO8
#tock is the aggregate of fully'paid up shares of a company consolidated for the purpose of facilitating its
division into factions of any denomination. )uthoried by its )rticles of )ssociation a company with a
share'capital may convert some or all of its fully paid'up shares into stock. .hen so converted, stock
represents the consolidated amount of the capital of the company. +t may be split'up or transferred in
fractions of any denomination, without regard to the original face value of the shares. #uch fractions bear
no distinctive numbers, but only represent specified parts of the consolidated capital. a stockholder may
transfer any fraction of the stock held by him.
3IFFE#ENE BET-EEN S"A#E AN3 STO8
1. 3ifference in Pai07up Amount 7 .hile a share may be partly paid up or fully paid up, a stock is
always fully paid up. &nly fully paid up shares can be converted in to stock.
BSPATIL CC
0. 3ifference in Nominal !alue .hile a share has a nominal value, a stock has no nominal value.
8. 3ifference in Tran(fera4ilit9 in Fraction( .hile shares cannot be transferred in fractions a
stock can be transferred to any fraction and sub'division.
=. 3ifference in 3i(tinct Num4er( .hile all shares bear distinct numbers representing the units of
share capital, stocks disclose the consolidated value of the share capital. %ractions of stock do not
any number.
3. 3ifference in 3enomination .hile all shares are of e"ual denomination, stock may be of
une"ual amounts and may be transferred in different fragments.
C. 3ifference in Offer to Pu4lic .hile shares may be issued to the public directly in the first
instance, stocks cannot be offered directly to the public. &nly fully paid up shares are converted into
stock.
D. 3ifference in #egi(tration .hile shares are always registered and nor transferable by delivery,
stocks may be registered and transferred only by delivery.
3EFE##E3 S"A#ES
(ublic companies in +ndia are not permitted to issue deferred shares. But in many other countries such
shares are issued by companies. in +ndia, these can be issued by independent private companies. deferred
shares are issued sub$ect to the condition that their holders will rank last of all in the matter of dividend
payment. The shareholders may not receive any dividend at all if the company makes a small profit.
!owever, if the company earns huge profits, they are entitled to receive even higher dividends that the
preference and e"uity shareholders. Thus deferred shareholders are often paid a high rate of dividend out
of the balance of profits left after payment of a dividend at a fixed rate to preference shareholders and at a
reasonable high rate to e"uity shareholders. &n account of the deferred claim on dividend the public are
not attract to these shares. They receive some compensation for their services by way of high dividend
which they en$oy in prosperous year. !ence deferred shares are also known as founders shares. These
shares are also issued to underwriters.
3ISTINTION BET-EEN 3EFE##E3 AN3 EBUIT= S"A#ES
1. Profit( Deferred shareholders are entitled to share in the redual profits of the company only after
the rights of the performance and e"uity shareholders have been satisfied.
0. Li<ui0ation +f the company goes into li"uidation, the deferred shareholders may get refund of
capital and participate in the surplus capital, if any, after the rights to preference and e"uity
shareholders have been satisfied.
8. #ig1t of Priorit9 Deferred shareholders do not en$oy the right of priority to have shares offered in
case of further issue of shares by the company.
=. Tran(fera4ilit9 Deferred shares are not freely transferable.
NO7PA# STO8
The no'par shares issued in the U.:., the U.#.). and 4anada are gaining popularity day to day. #uch
shares are not issued in +ndia.
5o'par stock means share having no face value. the total owned capital of the company is dividend into a
certain number of shares. #hare certificate only states the number of shares held by a particular holder
without mentioning the face value of shares. The value of share can be calculated by dividing the total
owned capital ;real network< with the number of shares. Thus the "uestion of difference between nominal
BSPATIL CD
value and market price of shares does not arise. +t is meaning less to issue shares at premium or at
discount. Dividend is paid by way of a given amount per share instead of certain percentage of the fixed
nominal value of shares.
ME#ITS OF NO7PA# STO8
1. True an0 correct Po(ition in t1e Balance Stoc, +n no par stock the balance sheet shows a true
and correct position of the business as there is no need for inflating the assets to offset inflated or
watered stock issues. The capital is always e"ual to the net worth and not an imaginary amount as
with shares of nominal values.
0. #eal )alue of "ol0ing( +n no'par stock as value of shares is related to the earnings, the
shareholders know the real value of their holdings which is always determined on the basis of net
assets of the company.
8. Ea(9 Mar,eting of S1are( +ssue of no'par shares avoids many legal formalities because the
"uestions of their issue at premium or at discount does not arise as there is not par'value of such
shares. This market marketing of such shares very easily.
=. No #e0uction of apital +n no'par stock as the value of shares is automatically ad$usted with the
earning capacity, there is no "uestion of reduction of capital at the time of reconstruction and
reorganiation of companies.
3. No Future all( +n no'par stock as the whole of the amount is collected in one sum at the time of
issue of shares the shareholders have no liability beyond the initial payment.
C. Free0om 5o par stock gives a complete freedom for fixing the price in the market that
commensurate with the prevailing conditions in the market and provides relief from the rigid legal
re"uirements. .hile at the initial stage a company can issue the shares at low prices its later
achievements may make possible the subse"uent issues at higher prices.
D. No manipulation of Account( ) company issuing no par stock need not manipulate its
accounts. +t has no motive to conceal the stock discount, underwriting commission and other costs
as these can be deducted from the sales proceeds of the shares.
G. orrection to o)er apitaliAation )s there is no face value, directors have every right to ad$ust
the value of capital to correct the over capitaliation.
1. areful Financial Stu09 )s the real value of shares depends very much on the earning capacity
of the company, it induces the investor to study the financial position of the company carefully.
3EME#ITS OF NO PA# STO8
1. No Stan0ar0 of !aluation 5o par shares have no standard on the basis of which valuation of
assets may be compared with capitaliation. Because the priced level is deceptive, the ignorant
investors may be decided. +nvestors cannot make valuation of their stock. +n the absence of par
value, they cannot $udge the fairness of return.
0. Manipulation of (ale( an0 0i)i0en0 +t offers enough scope to management to manipulate the
sale proceeds of shares and pay dividend out of capital. in the absence of any standard, the
management split the sale proceeds of stock into two or more parts. ) nominal amount may be
credited to the stated paid up capital account and the balance to the capital surplus which may later
on be utilied for dividend.
8. A4(ence of apital Planning There cannot be any planning for the financial need of the concern
which may lead the concern to over capitaliation or under'capitaliation.
BSPATIL CG
=. Un0er7Pa9ment( to Promoter( The flexibility of capital amount facilitates the promoters to pay
themselves unduly high remuneration for their services and for goodwill and concealing the losses.
3. No Securit9 to re0itor( The uncalled share capital provide an additional security to creditors
because it may be realied whenever necessary in case of par value shares. 5o par value share
provide no such security to creditors because the whole of the amount it called in one sum.
C. Balance S1eet 3ifficult in Un0er(tan0 5o par value shares render the balance sheet of the
company unduly complex and difficult to be understood by investors, creditors and tax authories.
D. Facilitation of Ta> E)a(ion +f no par shares are issued, taxation becomes complicated and tax'
evasion is possible.
G. 3ifficult alculation of #egi(tration Fee The fee for the registration of companies is charged on
the amount of )uthoried capital on par'value shares in almost all the counties of the world.
!owever, it is very difficult to calculate registration fee on companies issuing no par'value shares.
)s the above limitations of the no par value shares have created certain doubts in the utility of the issue,
no'par shares have now lost their popularity even in the U.#.).
TIMIN. OF ISSUES
The most noteworthy problem of securities is concerned with the selection of security to be issued to the
public according to prevailing capital market conditions. %or example, suppose an existing company ahs
already issued 02,222 e"uity shares of ,s. 12H' each fully paid. The market value of its shares is ,s. =0H'
per share. 5ot the said company wants ,s. =,22,222 as additional finance. The company should issue
e"uity shares for this finance. The company can issue only 02,222 e"uity shares N ,s. 02H' each which
share only a 3M voting control, if the market value of existing shares is ,s. GH' per share.
P#IIN. OF ISSUE
+f shares are issued to the public they may be offered to them either at par, at a premium or at a discount.
The price at which a new issue of shares is offered to the markets is based mainly on the price and yields
on comparable issues already "uoted. +t is decided by the Board of Directors after negotiations with share
brokers, underwriters and stock exchange authorities etc. The offered price must also appear attractive to
the investing public and under'writers. +t must be reasonable and commensurate with the risk involved and
write of control attached therewith.
+f the Board of Directors decides to issue shares at par there is no problem. But if it wants to change a
premium, the investors must be attracted by a profit potential to purchase these shares at premium. The
company-s management must take into account the market rating of similar companies in determining the
sale price of security. The strength of demand for new issues and the forecast of the level of maintainable
profits is also relevant. )lso important is the capitaliation factor i.e., (H7 ratio ;(rice * 7arning ratio< and
the denomination of the security. Bower denominations such as ,s. 12H' per share are more appealing and
convenient than higher denominations securities.
IMPAT OF T#A3E =LE
The total period of a trade cycle is divided into boom, recession, depression and recovery.
1. Boom +n boom period, the trend in the market is upward, the demand of capital increases and
conse"uently the rate of interest goes up.
BSPATIL C1
0. #ece((ion Under recession, the demand of products is much less than the production. this
period is $ust reverse of boom period. The trend is downward. The demand of capital and the rate of
interest go down. )s the investors prefer fixed income, the issue of preference shares or
debentures should be preferred.
8. 3epre((ion +n depression period the market is pessimistic. Therefore, raising funds is "uite
difficult. &nly fixed income securities are preferred.
=. #eco)er9 +n ,ecovery period the upward trend starts and the demand of risk capital begins.
To conclude in the words of 6erstenberg. EThe best time to raise funds is when business is booming and
people are optimisticF.
#I."T FINANIN.
+f an existing company seeks to issue new series of e"uity shares to finance its additional activities, it
should offer these shares to the existing shareholders at a specified price during a particular period. This is
a >right- or >(re'emptive rightF which may be defined as an option to buy a security at the specified price,
generally at par or at premium but much below the market price. The shares offered are called ,ight
shares. %inancing the pro$ects of a company by the issue of such shares is >right financing-.
)ccording to #ection G1 of the 4ompanies )ct a company may increase its further capital by issue of new
shares at any time after the expiry of two years from the formation of the company limited by shares or of
one year after the first allotment of shares in that company, whichever is earlier. These new shares must
first be offered to the existing e"uity shareholders of the company in proportion, as nearly as
circumstances admit, to the capital paid upon those shares at the time of offer.
P#OE3U#E OF #I."T ISSUE
%ollowing is the procedure of right issue according to the 4ompanies )ct*
Before making an offer to the existing shareholders the company will have to obtain the permission of
4ontroller of 4apital +ssus who takes decision on application for right issues in concurrence with the
company. #ome conditions may be imposed on the company making an offer of rights. The company
sends a >letter of offer- to the existing e"uity shareholders whose name are on the ,egister of members
mentioning therein the number of shares to which they are entitled in proportion to their old share holding
and the time within which the offer must be accepted. This period shall no bless than 13 days from the date
of offer. !owever it may be more than 13 days because the shareholders must have sufficient time to
make up their mind $udiciously. The offer must indicate that if it is not accepted within the specified period,
it shall be deemed to have been declined. +t must also state that they have the right to renounce all or any
of the shares offered to them in favour of their nominee;s<.
The shareholder shall inform the company within stipulated period about his acceptance of right or the
name of the nominee to whom he wants to renounce his right. !e may also apply for the additional shares.
But if he has renounced his right in favour of any person he is not entitled to apply for additional shares.
+f the right shares are not fully subscribed, the balance left over shall be distributed e"ually among the
applicants for additional shares with reference to the shares held by them in the company. (reference shall
be allowed to small holders in concurrence with the stock exchange on which the company-s share are
listed. The company may deal in any manner it likes with any balance left after making allotment of
additional shares.
BSPATIL D2
!ALUATION OF #I."T S"A#ES
The right shares are issued by the company at par or at a premium but normally at less than the ruling
market price, so that shareholders may offer the right with a hope of some capital gain. The gain on shares
is the value of right which may be calculated in the following manner.
%irst, the market price of the existing shares is calculate added to it is the issue price of right shares. The
total of these two prices is averaged which is the value of right share. The difference between the maerkt
price and the average price is the value of right. %or example, suppose a company makes right issue of
one share for every three shares held. The market value of existing share is ,s. 32 ;for ,s. 12H' #hare<.
The issue price of right shares is ,s. 02 per share. ;%ace value ,s. 12H'<
The value of right shall be calculated as under*
The total market price of three existing shares 9 32 x 8 9 ,s. 132
The issue price of right share 9 02
Total for = shares 9 ,s. 1D2
)verage (rice per #hare 9 ,s. 1D2 H = 9 =0.32
Kalue of right ;per share< 9 ,s. 32 ;'< ,s. =0.32 9 D.32
ME#ITS OF #I."T ISSUE
1. It Maintain( Pro7rata S1are ,ight issue give the existing shareholders an opportunity to maintain
their pro'rata share in the earning and surplus of the company and the voting power as before.
0. It increa(e( goo0:ill The goodwill of the company increases in the eyes of existing
shareholders.
8. It lo:er( co(t of i((ue The cost of issue of such shared will also be lower.
=. T1ere i( no 4ot1eration of (elling The financial management is relieved of the botheration of
selling the shares.
3. It pro)e( financial (tatu( +f right shares are accepted by the shareholders enthusiastically, it
proves that financial position of the company is sufficiently good, and the company can obtain more
loans at lower rate of interest.
ON3ITIONS OF P#IIN. T"E #I."T ISSUE
1. Amount t1e mar,et can 4ear +f the amount collected by issue of right shares is not invested in
securities yielding a good return or normal return, the market price of shares in the long run will go
down. +n that case, rights will not be used and investors will invest their funds in alternative
investment.
0. Mar,et price of (1are( The company should keep vigil on the market price and see how it
shares have been moving in the market in the past and how these are likely to move, if the rights
are fixed at a particular price.
8. T1e general price tren0 in t1e capital mar,et This mean the consideration whether the general
prices are stable or fluctuating. +f the trend is not stable, the investors will not like to invest funds in
securities and rights cannot be favoured.
BSPATIL D1
=. T1e profit earning capacit9 of (1are( +f the shares have no capacity to earn profit, they will not
be accepted by the shareholder howsoever low their price may be. &n the other hand, if profit
earning capacity of the shares are somewhat higher, regular and dependable, the rights will attract
the existing shareholders as well as their nominees even if rights are priced a bit hither.
3. T1e pro(pect( of propo(e0 plan( of e>pan(ion +f plans seem profitable, the right may be
priced a bit high. &n the other hand, if the plans are not attractive or slow, the price will be fixed
differently.
C. Nature of 3i)i0en0 polic9 +f conservative policy of dividend is adopted by the company, the
shareholders shall not be interested in purchasing the rights. !ere the price may be fixed much
lower. +f the shareholders are getting good dividend the price may be fixed somewhat higher.
D. T1e re(ource po(ition of t1e compan9 +f financial resource position of the company is sound,
the shareholders will be attractive to invest and the price may be fixed at somewhat higher level
otherwise the position will be reversed.
G. Fair return .hatever the pricing policy of rights, the enterprise should fix the premium, not so
low, nor so high. +t should yield the shareholders a fair return. The enterprise should strike a
$udicious balance between the two.
IMPAT OF #I."TS OF FINANE POLI=
%ollowing is the impact of ,ights on financial policy
1. Lo:er mar,et price of (1are( )s right shares are issued at a price much lower than the market
price of existing shares the market price is expected to fall to a considerable extent. This should be
considered by the company well in advance.
0. Spurt in .oo0:ill +f the existing shareholders decline the offer the shares are offered to other
persons at the same price. +f the company has a good record of payment of dividend, the
customers are tempted to purchase such shares at lower price even though, a decline in market
price is obvious, because they expect an increase in the market price of shares after a short spell
and if it is so, the goodwill of the company also goes up.
8. Lo:er 3i)i0e0 ,ight issue has an adverse effect on the market due to lower payment of
dividend. The dividend per share is lower due to increase in the number of share. +t is on the
presumption that additional amount realied through the issue of rights will not be put to profit
immediately and it will take time in increasing the profits. )ccordingly, even good shareholders
might feel disinclined to continue will the enterprise and begin to sell their holdings. #uch a trend
affects the market adversely and the price of shares goes down. The company should ensures a
healthy balance between the use of amount invested and the income from the investment.
=. S1are1ol0er@( capacit9 to purc1a(e (1are( +f shares are fully subscribed by the shareholders,
the market is not very adversely affected. +f the shareholders do not have capacity to purchase
shares, they either surrender their rights or renounce it in favour of their nominee. +f the nominees
also surrender such shares thereby making these sharers available in the market and the market is
affected adversely. Under such circumstances it is better to offer right in lower propositions.
3. Fluctuation in t1e mar,et price of t1e (1are( +f the shares are favorably traded in the market,
without having any fluctuation in the price to a considerable degree, the rights will attract the
shareholders and the price may be fixed somewhat higher. But if the shares fluctuate, the issue will
diversely affect the market and the company will have to fix the price of the right share much lower.
BSPATIL D0
C. Pre7offer pre((ure +n respect of that particular share market comes under heavy pressure in pre'
offer period $ust after it is known to the public that the company is about to offer right shares. This
pre offer pressure is usually considerably great and the financial management should make every
effort to check that pressure otherwise its financial policy will be adversely affected.
D. 3o:n:ar0 tren0 There are usually downward trends during the period of right issue. 7ven the
existing shares will come under heavy strains. +f the financial management does not move swiftly,
its whole financial policy might come under unbearable heavy strains.
O#PO#ATE 3EBT
) business firm obtain capital from the issue of ownership securities and by the issue of creditorship
securities. The amount collected by the issue of ownership securities is called owned capital. the amount
collected by the issue of creditorship securities is called debt capital. most of the business houses use debt
capital for financial re"uirements. +t may be of three types depending upon its period of use i.e., short term,
medium'term and long'term. 7xamples of short term debts are trade creditors, bills payable, bank
overdraft, and creditors for expenses. (ubic deposits and other loans of periods ranging from three to five
year are medium term debts. Bong term debts are obtained from specialied financial institution or by issue
of debentures and bonds to the public. Boans for which no security is issued are unfunded debts. Boans
against issue of security such as debentures or bonds are funded debts.
) company borrows capital in order to maximie the profits for its shareholders i.e., to pay higher dividend
to them. +t continues to use this source of finance until the increment return is higher than the increment
cost of debt capital. if the percentage change in the earnings is higher than the percentage change in the
cost of capital, the company prefers debt'financing. +n some exceptional cases, company accepts debt
capital at e"uilibrium point in which ;cost of capital 9 estimated earnings<. Thus, a company uses debt
capital to get the following advantages.
1. #etention of control )s creditors are concerned only with the interest due on their debts. They
are not entitle to vote and participate in management of the concern. The control is retained by the
shareholders as before.
0. Tra0ing on E<uit9 +t facilitates the company to trade on e"uity as the interest payable on debt
capital is fixed and lower than the rate of earnings. This maximies the dividend to the
shareholders.
8. Lo:ering of t1e o)erall co(t of capital The average cost of capital of e"uity shares, preference
shares and debentures is lowered down by the issue of debt capital as the cost of debt ;interest
payable< is very low in comparison to the cost of other capital ;dividends on preference and e"uity
shares<.
=. Ta>7A0)antage( +nterest payable on debt capital is and admissible expenditure in computing the
taxable income of the company while the dividend is not a deductible expenditure. Thus the cost is
reduced by the marginal tax rate applicable to that company.
3. Fle>i4ilit9 in apital (tructure Debt capital provides flexibility in the capital structure because
debt can be rapid if it no more re"uired by the business. #easonal re"uirements are met by the
debt capital.
C. Onl9 (ource for rai(ing fun0( #ometimes company gets it difficult to raise funds through any
other source except that through debts. )t times, especially during depression and recession, when
e"uity shares are not popular with the investors, debt capital is the only source for raising funds.
BSPATIL D8
D. Lo: co(t of #ai(ing Fun0( 4ost of issue of debt capital is much lower in comparison to e"uity
capital such as underwriting commission, expenses on certain formation etc.
LIMITATION ON 3EBT FINANE
) company cannot keep financing its affairs through debt capital to an unlimited extent. There are
following limitations on the debt financing.
1. #i(, of In(ol)enc9 Due to periodical fixed payment of interest and principal. 4reditors can claim
li"uidation of the company if it fails in meetings its obligation.
0. Uncertaint9 of Income +nterest on debt capital is a permanent charge against profits. ) company
should avoid debt capital if its income is uncertain and irregular.
8. o(t of Borro:ing 7xcessive, borrowing make debt funds costly and uneconomic. The cost of
borrowing increases with every successive borrowing.
=. u(tom( an0 on)ention( +n +ndia such as $ute, paper, electricity generation and distribution,
shipping etc. rely very much upon the debt capital due to customs and conventions of the industry.
3. ontractual Limitation +f creditors such is banks or financial institutions impose certain
restrictions upon the firm that further loan cannot be taken by the firm without their prior approval, it
becomes a limitation on its borrowing capacity.
C. Fluctuation( in t1e Income of S1are1ol0er( The debt capital creates fluctuations in the income
to the shareholders. The average is mainly governed by the degree of fluctuations in the rate of
return upon which e"uity holders investment is permitted by the management.
D. on(er)ati)e outloo, of management )s far as possible conservative management does not
rely upon the debt capital as the management loses its freedom by financing through debt capital.
in such companies the management prefer expansion and moderniation through internal sources
rather than using external sources.
G. 1ange in corporate ta> (9(tem #ometimes tax proposals may impose certain limitations on
debt financing.
MEANIN. OF 3EBENTU#ES
) debentures is an instrument executed by the company under its common seal acknowledgement
indebtedness to some person or persons to secure the sum advanced. +t is thus a security issued by a
company against the debt. +n +ndia, a public limited company is allowed to raise debt capital through
debentures after getting certificate of commencement of business, if permitted by its memorandum of
association. +ndian companies )ct says Edebentures includes debenture stock, bonds, and any other
security of a company whether constitution a charge on the assets of the company or notF. The definition
given by (rof. 5aidu and Datta runs as follows ? E) debentures is an instrument issued by the company
under its common seal acknowledging a debt and setting forth the terms under which they are issued and
are to be paidF.
1. They constitute the loans capital of the company.
0. Debentures ? holders are creditors of the company.
8. +nterest on debentures is paid at a fixed rate in periodical basis, such as six monthly, yearly etc.
=. ,edeemable debenture capital has to be refunded after prescribed period.
3. Debentures carry to voting rights except under special circumstances.
BSPATIL D=
C. Debenture holders can take legal action against the company, for and default in the matter of
payment of interest, or repayment of capital.
D. +n case of any default by the company, the debenture'holders have the right to claim the payment
of their dues from the sale proceeds of those assets. %or example if the company has created any
mortgage or charge on its assets to secure the issue of debentures.
G. Debentures holders can apply for winding up of the company if it is in their interest to do so.
A3!ANTA.ES OF 3EBENTU#ES ISSUE
)ccording to 6uthmann and Dooneall, EThe use of debentures and bonds takes a capital market
unavailable to the corporation which offers only stockF. %ollowing are the advantage of debentures in the
corporate finance.
1/ A3!ANTA.ES TO T"E OMPAN=
;i< Lo:er #ate of intere(t The rate of interest payable on debentures is fixed and usually lower
than the rate of dividend paid on shares.
;ii< Tra0ing on e<uit9 ) company is enabled to trade on e"uity by issuing debentures because
the rate of interest on debentures is usually lower than the rate of earning. Thus, the company
can declare a higher rate of dividend on e"uity shares.
;iii< Free0om in Management )s the debentures holders are not given any voting right to control
the affairs of the company, the company can raise the finance without surrendering control.
;iv< #e0uction i( ta> lia4ilit9 )s per income tax rules, the payment of interest on debentures is
charged against profits of the company. .hile dividend is an appropriation of profit and hence
not a charge against profit. !ence, the profits of the company are reduced by the amount of
interest paid to debenture holders resulting in reducing the tax liability.
;v< Suret9 of Finance )ccording to the new guidelines issued by the 6overnment of +ndia in
11G0, the secured debentures shall not be redeemable before a period of seven years. )s there
is a surety of finance for that specific period the company may ad$ust its financial plans
accordingly.
;vi< apital from Or0inar9 In)e(tor( ) company can collect the finance from such investors who
prefer fixed income with minimum risk rather than an uncertain high rate of dividend on capital
as security of capital is more important for them.
;vii< Finance 3uring Boom 7 During boom, a company can easily collect the finance through the
issue of debentures because the psychology of investors is affected by the trends of the stock
market.
;viii< Finance 3uring 3epre((ion +t there is a slump in the market, a company is not expected to
earn high profits, and the investors are not willing to invest their funds in share capital of a
company. Therefore, debentures are useful.
;ix< ontrol on o)er7capitaliAation The state of over'capitaliation is controlled by redeeming the
redeemable debentures, providing flexibility in the capital structure.
;x< on(oli0ation of 3e4t/ ) company may consolidate its debts of short duration by issuing
debentures and thus may reduce its cost of capital.
*/ A3!ANTA.ES TO IN!ESTO#S
;i< Fi>e0 an0 Sta4le income )s debentures carry a fixed rate of interest, an investor can
BSPATIL D3
estimate his income well in advance. Thus debentures provide a fixed, regular and stable source
of income to debenture holders.
;ii< Safe In)e(tment )s debentures holders have specific or general charges on the assets of the
company, so their investment is "uite safe.
;iii< Li<ui0 In)e(tment Debentures are more li"uid investment, and have more ready market
because they are safe and can be used as collateral security by the investors in raising loan
from any financial institution. Under the new guide'lines ;11G0<, the >rights- and secured
;convertible and non'convertible< debenture shall be listed in a stock exchange.
;iv< on)er(ion of Loan( +n convertible debentures, debenture holders can convert their holdings
in shares at appropriate time.
3ISA3!ANTA.ES OF 3EBENTU#E ISSUE
1/ 3ISA3!ANTA.ES TO OMPANIES
;i< Fi>e0 1arge on A((et( )s debentures carry a fixed charge on all assets of the company,
the company cannot raise loan on such assets again, if needed.
;ii< Fi>e0 Bur0en +nterest payable on debenture is a charge on the profits of the company, which
has to be paid even if there is no profit. This is a burden on the company particularly when there
are no profits or inade"uate profits.
;iii< #i(, of -in0ing up +f the interest on debenture is not paid by the company, the debenture
holders have a right to claim winding up of the company. Therefore, debentures issues is risky
in lean periods.
*/ 3ISA3!ANTA.ES TO IN!ESTO#S
;i< No ontrol )s debentures holders are creditors and not the owners of company they get
no controlling authority over the affairs of the company.
;ii< S1are in Profit( )s debenture holders get a fixed income as interest irrespective of the
"uantum of profits earned by the company, they do not share the profits even if a company
earns huge amount as profits.
;iii< Uncertaint9 of #e0emption 7 +n case of redeemable debentures payable within a specified
period, investors have uncertainty in their minds as to their redemption.
-"EN TO A!OI3 3EBENTU#E ISSUE
&nly a company having stability in income, can safety issue debentures to finance its long and medium ?
term re"uirements for the purpose of improvement and extension. +n the following conditions a company
should avoid issue debentures.
;i< %luctuating earning.
;ii< Bow proportion of fixed assets to total assets as there is no substantial security to offer to
debenture holders.
;iii< Aanufacturing and supplying products with highly elastic demand such as luxury items.
;iv< 5o sufficient profits to pay off interest on debentures.
BSPATIL DC
T=PES OF 3EBENTU#ES
)ccording to different points of view following are the types of debentures.
1/ F#OM #E3EMPTION POINT OF !IE-
;i< #e0eema4le 3e4enture( ,edeemable debentures are to be repaid by the company at
the end of he specified period or within the specified period. +t is at the option of the
company to give notice to debenture holders of its intention to redeem debentures at once
or by installment under the terms of issue.
;ii< Irre0eema4le 3e4enture( These debentures are repayable at any time by the company
during its existence. .ith no minimum fixed period these are redeemable if the company
fails to pay regular interest on them. These are also called perpetual debentures.
Debentures holders cannot claim their repayment during the life time of the company.
*/ F#OM SEU#IT= POINT OF !IE-
;i< Na,e0; Un(ecure0 or Simple 3e4enture( These debentures carry no specific charge on
the assets of the company about the repayment of principal and interest. But being creditors
of the company, the debenture holders have general charge on the assets of the company.
;ii< Mortgage or Secure0 3e4enture( These debentures are issued with a charge ;fixed and
floating< on the assets of the company which may be on a particular asset or on all assets in
general. %or this purpose, regular deed is ended into between the company and the trustees
of the debenture holders.
+/ F#OM T"E POINT OF !IE- OF T#ANSFE#
;i< #egi(tere0 3e4enture( These debentures are registered with the company with names,
addresses and particulars of holdings recorded in a Debenture holders register. ) regular
transfer deed giving full particulars of transfer and transferee is re"uired at the time of
transfer of such debentures.
;ii< Bearer 3e4enture( These debentures are payable to the bearer. These are transferable
by delivery only. These are negotiable instruments and the company keeps no records for
them. +nterest is paid to the coupon holder.
5/ F#OM P#IO#IT= POINT OF !IE-
;i< Fir(t 3e4enture These are those which are to be paid first in the event of winding up of
the company.
;ii< Secon0 0e4enture( These are those which are to be repaid after the payment of first
debenture has been made.
6/ F#OM ON!E#SION POINT OF !IE-
;i< on)erti4le 3e4enture( !olders so these debentures are given an option to convert
their holdings into shares under certain conditions and limitations mentioned in the
debenture certificate regarding the period during which he option may be exercised.
BSPATIL DD
;ii< Non7con)erti4le 3e4enture( These debentures cannot be converted into shares.
D/ OT"E# T=PES OF 3EBENTU#ES
;i< ollateral 3e4enture( These debentures are issued by the company for the loan taken
from a bank or a financial institution as collateral security. These are effective only when the
company fails to pay the loans.
;ii< .uarantee0 3e4enture( )t the time of their issue the payment of principal and the
interest on these debentures is guaranteed by some third party generally banks or
governments.
;iii< #ig1t 3e4enture( These debentures are issued by the company to its resident
shareholders in the fixed proportion of their shareholdings. #uch issue seeks to augment the
long'term resources of the company for working capital re"uirement and to reduce its
dependence on other short'term resources. These debentures cannot be issued for
expansion and moderniation purposes. They will first be issued to existing shareholders
and then to shareholders in addition to their >right- depositions and employees and business
associates on a rational basis.
#E3EEMABLE 3EBENTU#ES
,edeemable debentures are those that will be repaid by the company under the term of issue at the end of
a specified period or at any time within a specified period by giving them a notice of its intention to redeem
them at the end of the notice period or by installments during the existence of the company. ,edeemable
debentures may be reissued even after they have been redeemed until they been cancelled.
A3!ANTA.ES OF #E3EEMABLE 3EBENTU#ES
1. Fle>i4ilit9 in capital Structure By issuing such debentures the company can make its capital
structure more flexible, and raise funds as and when it needs the loan money.
0. 1ec, on O)er capitaliAation )n over capitalied company may redeem such debentures and
may control the state of over capitaliation.
8. Be(t (olution for Fi>e0 Term Loan +f a company re"uires funds for a fixed period it may issue
such debentures because these can be redeemed after a certain specified period.
=. Preferre0 49 Fi>e0 Term In)e(tor( These debentures are preferred by those investors who with
to invest their funds for a fixed term at a fixed rate of interest and at minimum risk.
3ISA3!ANTA.ES OF #E3EEMABLE 3EBENTU#ES
1. Li<ui0ation of ompan9 ,edeemable debentures are repaid at the end of a certain specified
period or at any time within the specified period by giving them notice of redemption. +f the company
fails to arrange the necessary amount to redeem them the debenture holders can take action for its
winding up. The company-s existence is always at stake if its financial positions is not sound
enough.
0. Uncertaint9 of #e0emption +f debentures are repayable at any time within a specified period
under the terms of issue, it may create a problem before the debentures holders to invest the
amount immediately as soon as it is repaid by the company. There remains uncertainty in the minds
of debentures holders regarding its redemption.
8. A0)er(e effect on li<ui0it9 of A((et( +f a company has to repay a large sum at the time of
BSPATIL DG
redemption of debentures it may adversely affect the li"uidity of assets unless it is planned wisely
by creating sinking fund so that the company may get the re"uired amount at the time of
redemption of debentures at the end of the specified period.
ON!E#TIBLE 3EBENTU#ES
4onvertible debentures are those which are convertible into shares at the option of the holders after
a specified period. These are a means to deferred e"uity financing. ) company intending to raise additional
e"uity capital at a particular time may find that the prevailing conditions in the capital market are not
congenial or the issue of e"uity shares. The investment pro$ect which is not likely to yield profit may not
succeed initially. Therefore, the company may issue debentures with the provision that holders will have
the optimum of converting them into e"uity shares after a few say 8 to 3 years.
A3!ANTA.ES TO ISSUIN. OMPAN=
1. #i(e in E<uit9 apital By such issue a company can rise e"uity capital indirectly without diluting
the earnings of the existing shareholders. By the time debentures are converted into shares the
additional investment starts earning an added return to support the additional shares.
0. Sale of S1are( in 3i(gui(e +n a period of low market prices of shares the company can sell
e"uity shares in disguise. +nvestors unwilling to purchase e"uity shares, initially, may like to convert
their debentures into e"uity shares if they find, it to be a profitable proposition.
8. Attract( Fun0( from In(titution( By issuing convertible debentures, a company can attract
funds from the institutions which may not otherwise purchase e"uity shares due to restriction
imposed by their by ? laws.
=. Ta> A0)antage )s the interest on debentures is a charge on profits, the company gets tax
advantage until the bonds are converted into shares.
3. .reater appeal 4onvertible debentures may have greater appeal among the investors
particularly in a period of tight money. The addition of conversion right allows the company to offer
comparatively a lower rate of interest in a period when prices of other bonds are falling due to rise
in the interest rates.
C. Securit9 for Ot1er 3e4t( )s convertible debentures are unsecured and therefore the borrowing
capacity of the company remains intact by the issue of such bonds, the company can provide
security against its other debts.
D. Fle>i4ilit9 of apital (tructure The issue of convertible debentures results in an element of
flexibility to the company-s capital structure.
G. 3ou4le Benefit( 4onvertible debentures offer benefits of both debt financing and e"uity
financing.
#I."TS 3EBENTU#ES
Under #ection G1 of the +ndian 4ompanies )ct 113C, there are specific provisions regarding the issue of
Erights sharesF by the public companies while no such specific provision has been made regarding the
issue of rights debentures. (ublic companies are authoried to issue such debentures for raising long'term
resources. The central government has formulated certain guidelines to regulate the issue of rights
debentures by public companies for working capital re"uirements to be followed by a company, while
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seeking consent of the controller of capital issue.
.O!T/ .UI3ELINES
6ovt. concerning rights debentures guidelines are as follows*
1. These may be issued by only public limited companies
0. These may be issued to augment working capital on a long'term basis. +ssue of debentures for any
other purpose such as financing of expansion pro$ect or addition to fixed assets will not fall under
this category.
8. The amount of the issue will not exceed 02M of the gross current assets, loans and advances
minus the long'term fund currently available for working capital, or 02M or the paid'up share
capital, including preference capital and free reserves, whichever is lower of the two.
=. The debt'e"uity ratio including the proposed debenture issue, should not exceed ++.
3. The debenture will carry a rate of interest 12.3M payable half'yearly where the period of maturity is
up to and including D years and 11M where the period of maturity is from G to 10 years.
C. ,ights debentures can be issued at a discount or additional interest of O M can be offered for any
year, if in that year the rate of dividend on e"uity shares is highest in the preceding three years.
D. ,ights debentures will be redeemable as follows*
a. .here the maturity period is upto D years, 88 1H8M of the debentures will be repaid
uniformly to all debenture holders in the 3
th
, C
th
and D
th
year.
b. .here the maturity period is from G to 10 years, 02M of the debentures will be repaid
uniformly to al the debenture holders in the G
th
, 1
th
, 12
th
, 11
th
, and 10
th
year.
G. The face value of each rights debentures will be ,s. 122
1. ,ights debentures will be listed with the stock exchange.
12. The issuing company should be a listed company. +ts e"uity shares must be "uoted on the stock
exchanges at or above par value in six months prior to the date of application for the issue.
11. ,ights debentures shall first be offered to the existing +ndian #hareholders of company on a pro'
rata basis and there after must be kept open for at least two months. The un'subscribed
debentures, if any, will be offered on a rational basis to ;a< shareholders interested in taking up
additional allotment, ;b< the directors of the company, and ;c< the employees and business
associates of the company.
10. )llotment of ,ights Debentures will be made only after a minimum subscription of D3M of the
amount of debentures has been secured.
18. The company should ascertain beforehand the prospects of at least D3M of the issue being take up
by the shareholders of the company and other categories of investors mentioned above.
#E!ISE3 .UI3ELINES 1FG5
The government of +ndia issued a set of guidelines by a notification in &ctober 11G2 in order to regulate the
issue of debentures. These guide'lines were revised in 11G1 and 11G0. +n #eptember 11G= the
6overnment of +ndia announced following fresh guidelines for issue of secured convertible as well as non'
BSPATIL G2
convertible debentures by public limited sector companies.
1/ OBJET OF ISSUE
;i< #etting up of new pro$ects.
;ii< 7xpansion or diversification of existing pro$ects.
;iii< 5ormal capital expenditure for moderniation
;iv< AergerHamalgamation of companies in pursuance of schemes approved by banksHfinancial
institution and H or any legal authority.
;v< ,estructuring of capital as approved by banksHfinancial institutions andHor any other legal
authority.
;vi< )c"uisition of assets in accordance with legal provision and H or A,T( )ct. and
;vii< To augment long'term resources of the company for working capital re"uirement.
0. Buantum of I((ue The amount of debenture in the case of working capital shall not exceed 02
percent of the gross current assets, loans or advances. +n case of over subscription the companies
may be permitted to retain subscription for non'convertible debentures upto a maximum of 32
percent over the original issue.
8. 3e4t7E<uit9 #atio The debt'e"uity ratio shall not normally exceed 0.1
=. Intere(t #ate in case of convertible debentures, the rate of interest shall not exceed 18.3 percent
year while in case of non'convertible debentures, the rate of interest should not be more than 13
percent per year.
3. Perio0 of #e0emption Debentures shall not normally be redeemable before the expiry of the
period of D years.
C. Price at t1e time of re0emption ) (remium upto 3 percent of the face'value can be allowed at
the time of redemption in the case of non'convertible debentures only.
D. 3enomination The face value of the debentures will ordinarily be ,s. 122 each.
G. Li(ting The debentures shall normally be listed stock exchanges.
1. Securit9 &nly secured debentures will be permitted for issue to the public.
12. Un0er :riting The issue of debentures shall be under written.
11. Li(ting of S1are( of ompanie( propo(ing 0e4enture( i((ue The shares of the company
proposing to issue debenture must be listed in one or more stock exchange. #imultaneous listing of
shares and debentures of companies will also be permitted. The provision regarding listing of
shares is not applicable to public sector undertakings.
3EBENTU#ES UNPOPULA# IN IN3IA
1. "ig1 3enomination +n +ndia, debentures are usually of high denomination, as +ndia investors
prefer securities of low denomination, the moderate investors could not go in for them.
0. Managing Agenc9 S9(tem +ndian industries were financed primarily by the managing agents
who generally discouraged the issue of debentures for fear of loosing their financial importance.
8. "ea)9 Stamp 3ut9 Debentures have been a very costly source of finance with a heavy
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stamp duty of ,s. 13 for ,s. 1222 for bearer debentures and ,s. D.32 per ,s. 1222 for
registered debentures. This heavy stamp duty generally discourages the investors to invest
funds in debentures.
=. A0)er(e Attitu0e of Ban,( Banks and other financial institutions show an adverse attitude
towards companies which issue debentures. Banks did not entertain the debentures even as
collateral securities. +ssuing 4ompanies lose their credit in the eyes of banks and other financial
institutions.
3. Limite0 Mar,eta4ilit9 %or debentures there is no developed, regular and steady capital
market in +ndia. To increase the marketability of industrial securities the 6overnment of +ndia
have recognied many new stocks exchanges in different part of the country.
C. A0)er(e effect of .o)ernment (ecuritie( 6overnment of +ndia have issued so many
securities with attractive conditions which have adversely affected the popularity of debentures
in +ndia. )s compared to the industrial securities government securities are considerably safer.
+nstitutions investors have to invest their funds in government securities as per statutory
provisions.
D. Unattracti)e term( of i((ue Terms of issue of debentures in +ndia are not as attractive as
they are in some other industrially developed countries.
G. Lac, of Proper A0)i(or9 Agencie( There is a total lack of advisory agencies investment in
+ndia. #tock exchange services are confined to some big cities. +nvestment trusts and
investment banks are not developed in +ndia. Therefore the investor cannot $udge where to
invest the funds.
1. Lac, of Intere(t to In0u(trial In)e(tor( +nstitutional investors are statutorily re"uired to
invest a large part of their funds in government securities. %or example, +ndian +nsurance )ct
1181 prohibits investment in debentures by insurance companies in +ndia. 7ven to day Bife
corporation invests its G2M of funds in government securities. 6enerally +ndian banks do not
invest in long'term corporate securities. +nvestment bank and investment trust have not
developed much in +ndia. ,ecently, Unit Trust of +ndia as show some interest in corporate
debentures.
12. autiou( Attitu0e of In0ian In)e(tor( +ndian investors are very cautions about the safety of
their investment. They do not wish to earn more at the cost of safety. &nly safety of investment
attracts them to invest funds in gilt'edged securities.
11. Preference for .o)ernment Sa)ing( +n recent years +ndian government have initiated a
number of attractive saving schemes and issued securities which carry income tax rebates and
other benefits like withdrawals etc. Aarginal investors prefer these schemes rather to invest
funds in debentures.
10. Limite0 ontrol of "ol0er( Debenture holders are given limited controlling power in the day
to day affairs of the company unless their interests are affected. They have no vice in policy
decision of the company unless they affect their interest. !ence those who desire to have a
voice in the affairs of the company prefer to invest their money in e"uity shares.
STEPS TO MA8E 3EBENTU#ES POPULA#
+n recent years the government have taken several steps to make debentures a popular source of
finance. )s against a meager 12 percent in 11CC'CD, today debentures capital accounts for more than 1H8
of the total corporate funds. %ollowing steps have been taken by the govt. to make debenture popular as a
BSPATIL G0
source of finance of +ndia.
1. Attracti)e term( Debentures with attractive terms such as convertible debentures have been
issued. 4onvertible issued by well'known companies like T7B4&, ,eliance +ndustries Btd., etc.
have been over'subscribed.
0. on)er(ion into (1are( The conversions of debentures into shares encourages the institutional
investors to invest in debentures.
8. #ela>ation in Stationar9 re(triction( #tatutory restriction on the institutional investors like B+4
and +%4 have been relaxed. !ence they feel encourage to have debenture in their investment
portfolio.
=. Ban, cooperation There has been a market change in the attitude of banks which no longer
consider a company issuing debentures as less credit'worthy.
3. Un0er:riting facilitie( The development of issue and underwriting facilities have enhance the
market for debentures.
C. Tru(tee (er)ice Trustee services are being made available to debenture holders.
D. Better Securit9 t1roug1 Joint I((ue #ometimes companies under the same management
combine to make a $oint issue of debentures. )s a result they are able to offer better security to
investors in the form of assets and the cost of issue is distributed.
G. Ta> Sa)ing( (ayment of interest on debentures allowed as an item of expenditure under the
+ncome Tax )ct. This has acted as a spur to companies to issue debentures. Bess formalities have
to be observed while issuing debentures. The benefit of trading on e"uity is also available.
#ome of the steps which are likely to increase the popularity of debentures in the country are re'
organiation of the capital market to provide better marketing facilities for debentures, change in
attitude of banks towards debentures, more attractive terms to debenture etc.
MEANIN. OF PUBLI 3EPOSIT
The term Epublic depositF includes money received by a non'banking company by way of deposits or loan
from the public including the employees, customers and shareholders of the company other than in the
form of shares and debentrues. +n order to meet their medium ? term and long'term re"uirements +ndian
fiancP companies have been receiving public deposits for a long time. Before independence, banking
facilities in the country were not well developed. (eople preferred to deposit their saving with reputed
companies. in the recent years (ublic deposits have again become popular as rates of interest offered by
companies are higher than those offered by banks. The cost of deposits to the company is less than the
cost of borrowing from banks. 4ompanies generally accept public deposit varies from 10 percent to 13
percent depending on the period of deposit and reputation of the company.
P#OE3U#E OF PUBLI 3EPOSIT
)ccording to the 4ompanies ;)cceptance of Deposits< ,ules 11D3 as amended in 11G=, no company can
receive secured and unsecured deposits in excess of 12 percent and 03 percent respectively of the paid up
shares capital plus free reserves. #ince )pril 1, 11G2, public sector companies have been also permitted to
invite public deposits. The company which intends to raise public deposits approaches the public through
an advertisement in the press about the progress and prospect of the company to induce the public to
BSPATIL G8
deposit their surplus money with the company. The depositors may withdraw their balance after the
specified period or after giving notice. The receipt of public deposits is governed by the rules made by the
4entral 6overnment under section 3G) and B of the 4ompanies )ct and directions issued by the ,eserve
Bank of +ndia.
A3!ANTA.ES OF PUBLI 3EPOSIT
%ollowing are the advantages of public deposit *
1. Simplicit9 ,aising capital through public deposits is a relatively simple affair. There are few legal
formalities. The company receiving deposits is only re"uired to issue a receipt to each depositor.
0. Economic (ublic deposits are cheaper to raise. By only advertising in the newspapers for public
deposits the company can collect the necessary funds in a short period. +t can save on underwriting
commission, brokerage etc. Thus interest on public deposits works out to be much less than liability
in the form of dividend on shares or interest on debentures.
8. Tra0ing on e<uit9 %uns raised through public deposits enable the company to trade on the
e"uity. )s interest on public deposits is paid at a fixed rate, the entire remaining profits are available
for distribution among e"uity shareholders of the company.
=. !alua4le (ource of (1ort7term finance (ublic deposits are a valuable source of shot'term
finance. They prove very useful in case of companies depending on raw materials which is
available only in a particular season of the year and for meeting other short'term liabilities. These
companies can buy enough "uantities of raw materials through such deposits. )s the sale of their
finished product picks up, they are enabled not only to pay interest on the deposits but also to save
for the eventual repayment.
3. No c1arge on a((et( (ublic deposits do not create any charge or mortgage on the company-s
assets like debentures. Thus the company may raise loans against the security of its assets to meet
other re"uirements.
3ISA3!ANTA.ES OF PUBLI 3EPOSIT
;i< Uncertain ) person who has made a deposit with a company can withdraw his at any time he
pleases on the only condition that he has to give a prior notice to the company. Though this
facility helps the depositor, premature withdraws by depositors, may effect the company-s
financial position, particularly if its earnings have become unstable. The company may find it
difficult to honour its commitment and repayment, if a large number of depositor decide to
withdraw their deposits at a time when the business in general is faced with depression and
slump.
;ii< Fair :eat1er frien0 The company may be flooded with deposits when its earnings show a
rising trend. But in times of financial crisis the depositor might desert it as a sinking ship is
deserted by its crew.
;iii< #ec,le(( tra0ing an0 (peculation )s raising of deposits from the public is relatively
BSPATIL G=
simple and inexpensive affair, sometimes it tempts the companies to raise more funds than they
can profitable use. This results in over'trading or speculation activities on their part, with harmful
conse"uences for the business of the undertaking.
;iv< Little attraction for profe((ional in)e(tor( (ublic deposits do not hold much attraction for
professional investors as a mode of investment. (rogressive investors do not opt for deposits
because of low return and absence of capital appreciation. The conservative investors keep
away from making deposits due to absence of proper security in the form of a mortgage or
charge on the assets of the company.
;v< "ammer to gro:t1 of capital mar,et (ublic deposits hamper the growth of a sound
capital market in the country. )s the companies find it easy and economical to raise money
through public deposits they are not very keen to raise money by issue of shares and
debentures. Thus, investors are deprived of the benefits accruing from good securities.
;vi< Uneconomical +f better investment opportunities are freely available, the public will not keen
to make deposits unless very high rates are offered. The company raising money through public
deposits has to spend a lot by way of commission and brokerage. Thus, in the ultimate analysis
this sources of capital proves to be costly.
MET"O3S OF #ETI#IN. OF LON. TE#M 3EBTS
) company has to redeem every debt'except the irredeemable debentures. .hich are to be repaid
at the option of they company at any time after giving a due notice to the debentures holders. %ollowing are
the three principal methods repayment of long'term indebtedness* ,edemption, ,efunding and conversion.
1. #e0emption ,edemption involves cash payment to the debenture holders or bond holders either
at or before the date of maturity according to the terms of contract. (ayment is made ;i< at maturity,
;ii< before maturity under terms of issue, and ;iii< after maturity not under the terms of contract but
under a subse"uent agreement.
;i< At maturit9 (ayment is made on the due date out of cash which may be made available
either out of current earnings or out of sinking fund created out of profits established to
ensure payment of debentures at maturity. +nvestment against sinking fund are sold out and
loan is redeemed in order to make cash available.
)s a company cannot redeem its entire bond issue from the earnings of any one year, a sinking
fund is built up out of profits over a number of years without in$uring the financial operations of the
company. +t is invested in various securities, especially in gift'edge securities, in such a way that total
amount of indebtedness is collected including interest, on investment after a fixed period. %ollowing are the
main reasons for creating sinking fund.
;a< Securit9 +t adds the element of security.
;b< onfi0ence +t tends to inspire the confidence in the capacity of the issuing company.
;c< 1ec, +t acts s a check on the financial policies of the management due to appropriations of
profits for the fund.
;d< "ig1 cre0it The company is rated high because the company invests the amount e"ual to the
fund in the open market securities, which tends to stabilie the market value of bonds at a relatively
high level.
BSPATIL G3
;e< Ma,e( up 0epreciation +t makes up the depreciation in the value of assets purchased out of the
sale proceeds of bonds.
;ii< Before maturit9 ) company may redeem debentures even before maturity which may be
mandatory or solicited. This is as follows*
;a< +f its mandatory, the bounds are chosen by lot for redemption. The issuing company
reserves the right to redeem the debentures as given under the terms of debenture
agreement at the time of issue. (ayment may be made in fixed installments year after
year. The number of debenture to be redeemed in a year is Edrawn by lotF. #lips
containing distinct number of debentures of bonds are put in a drum and then as many
slips are taken out as the debenture to be redeemed. The debentures thus drawn by lot
are repaid in cash and full under terms of contract.
;b< +f redemption is solicited before maturity, an agreement is entered into between the
company and the debenture holders.
;c< ) company may redeem debentures before maturity by purchasing them in the open
market. +f the terms of issue do not restrict the company from doing so the company may
cancel these debentures after their purchase in the open market.
) company is promoted to redeem before maturity a due to the following reasons*
;a< To eliminate fixed charge on the earnings of the company provided the li"uidity position of the
company is not adversely affected.
;b< To get rid of onerous terms and conditions of the bond.
;c< To redeem debentures either by taking them back direct from the debentures holders or by
purchasing them from the open market.
;d< To provide flexibility to the financial plan of company.
0. #efun0ing ,efunding of indebtedness means replacement of old debt into new instead of
extinguishment of debt altogether a is done in redemption. This may take place either or maturity or
before maturity.
&a' On maturit9 t1i( ma9 4e 0one in t:o form(
;b< Before maturit9 This is done by exercising call option given under the terms of issue or if no
such optionis given in the managemnet, the company may enter into a first agreement with the
bond holders including them to accept new series of debenture or to accept cash before
maturity. %ollowing types of inducements are offered to the bondholders for persuading them to
accept new bonds.
;i< 5ew bonds may issued at a discount to the existing debentures.
;ii< +t is likely to find favour with the old bondholders.
;iii< The bondholders of small issues may have the advantage of better security by
consolidating the issue with after ac"uired property clause.
;iv< 5ew issue may be guaranteed by the parents company affiliated company or
government of financial company.
;v< &ld debentures may be redeemed at premium.
;vi< Debenture may be paid partially in cash and bonds for the balance.
BSPATIL GC
+f the bondholders insist on cash payment, it may be arranged to make the new issue under written with the
bankers. %ollowing are the reasons for refunding before Aaturity*
;i< To reduce fixed change.
;ii< To eliminate bonds containing prohibitive term and conditions by offering new bonds in
favourable market.
;iii< To consolidate several bonds containing different terms and conditions.
8. on)er(ion 4onversion means issue of shares to the existing debentures holders in exchange of
their holdings under the terms and conditions specified in the contract of issue. The debenture
holder is given a right to convert the debentures within a specified period according to the terms
given in the bond indenture. The company retires it as debt by converting debentures into e"uity or
preference shares. The main purpose of issuing convertible debentures is to make the financial
plan of the company highly elastic because such debentures may be redeemed at any time before
maturity. To conclude the redemption of debentures is preferred when the company has sufficient
cash to pay off the debentures. &n the other hand, if the company lacks funds to pay off debentures
in cash, it issues a new series of debentures. +f the company likes to continue the indebtedness for
the purpose of trading on e"uity or due to favourable market conditions, it may adopt the method of
refunding.
3EBT FINANE A.AINST EBUIT= FINANE
Debt %inancing is recommended against e"uity financing due to following reasons*
1. The rate of interest payable on long terms debt is lower than the normal rate of return.
0. The cost of debt'financing is always fixed.
8. The interest payable on debt is an admissible deduction for income'tax purposes which reduces
tax liability of the corporation.
=. Debt carries flexibility in the capital structure of the company because it can be redeemed at any
time at the sweet will of the company.
%ollowing are the circumstances of accepting debt capital.
;1< The sales and earnings are relatively small
;0< The marginal cost of debt is less than the cost of e"uity as it lower the average cost of capital or
trading.
;8< The general price level is expected to be high, resulting in higher profits in future.
;=< The existing debt'ratio is relatively low.
;3< (rice earnings ratio on e"uity shares is low in relation to the level of interest rates.
;C< ,etention of existing control pattern because debentures carry no voting rights.
;D< Terms of debt'agreement are not burdensome on the cash position of the company.
;G< Terms and conditions of debt agreement are not onerous and pre$udicial to the interest of the firm
and its shareholders.
SUITABLE 3EBT MANA.EMENT POLI=
BSPATIL GD
)n optimum debt policy depends on expected ratio of returns and the rates at which these expected
revenue streams will be capitalied. 5o matter how much it shifts towards debts a company can never
lower its average cost of capital unless it chalks out or maintains a suitable debt management policy, which
means a balanced and cautious debt policy to remove the fluctuations in the earnings per share.
;i< In t1e 9ear( of pro(perit9 Through earnings per share will increase if the company relies
more on debts rather than e"uity financing but it creates its own problems that all manages
cannot appreciate because it restrains the freedom on the working of financial policies.
;ii< In t1e perio0 of 0epre((ion +t is not interest of the organisation and the shareholders to raise
debt capital because the average rate of earnings is much lower than the rate of interest
payable on such debts. The company must follow the policy of balanced debt financing policy in
order to avoid sharp fluctuation in the earning per e"uity share.
PLOU."IN. BA8 OF P#OFITS
(loughing back of profits is a management tool under which management does not distribute the whole of
the profits earned during a year to the owners of capital but it retains a part of it to be utilied in future for
financing the schemes of development and betterment of the company and H or meeting the special fixed or
working capital re"uirements of the concern. +t is the best devise to finance the schemes of expansion,
moderniation, and betterment for an existing company. (loughing back or re'investment of profits is and
ad$unct of sound financial management. +t raises no problem or complication as does borrowing either from
the banks or from the public. The reserves may be built up during a continuously spell of prosperous period
by following the conservative dividend policy and without touching the capital structure of the company and
may be used during emergency. +t will help the company during depression however serious. )ccording to
this device, a part of the total earnings may be transferred to various reserves, e.g., 6eneral ,eserves,
,epair and ,enewal ,eserve %und etc. #ometimes secret reserves are created by the directors without
the knowledge of the shareholders to make the financial position of the company sound. +t is a desirable
practice to stabilie the economic soundness of the company.
1/ A3!ANTA.ES OF PLOU."IN. BA8 OF P#OFITS
;i< A( a S1oc, a4(or4er in t1e Bu(ine(( The policy of ploughing back of profit provides a
cushion to absorb the shocks of business vicissitudes. +t is well known that prosperity does not
last for ever. (eriod of boom is always followed by depression. +n depression past earnings
enable the company to withstand the seasonal reactions and business fluctuations and act as a
shock'absorber in the business.
;ii< No 3epen0ence on Fair -eat1er Frien0( ,etained earnings, may be called >)ll weather'
friend-. +n the absence of ploughing back of profits a company has to manage its funds for
expansion or development through other sources of long'term finances such as issue of shares
or debentures or borrowings from long'term financial institutions or public deposits. There are
labeled as fair weather friends because a company can manage its finance through these
sources only in prosperity. +n adversity, these source cannot be realied upon. &nly retained
earnings can be utilied for such development schemes.
;iii< Economic Met1o0 of Financing H (loughing lack of profits is a cost free sources of finance as
nothing is paid to retain the profits. +f a company issue shares or debentures of borrows money
from financial institutions or public to finance its schemes of development, it will have to pay
dividends or a fixed rate of interest on such financing. Aoreover, interest on borrowings is a
BSPATIL GG
charge on the profits of the company. +t is to be paid whether profits are available or not. But if
reserves are used for such purpose, no such obligations of dividend or of interest is incurred.
;iv< Be(t 0e)ice Financing of #ationaliAation (loughing back of profits is the best device in
financing rationaliation schemes. ,etained earnings may be employed when a company
expands its business or implements any scheme of development, mechaniation, automation
etc. +n comparison to other sources of finance, there are three additional charms of this device.
a. There is no dependence on outside sources
b. 5o charges or encumbrances is created on the fixed assets of the company.
c. There is no cost of retaining earnings.
;v< 7nsure stable Dividend (olicy ? ,etained earnings ensure stable dividend policy and
enhance the credit standing of the company in the market. 7ven if the earnings of the company
are not stable and regular it may maintain a consistence rate of dividend to the shareholders in
prosperity and transfer any excess to a reserve which may be called Edivided e"ualiation fundF.
.hen the earnings of the company are below the normal rate of earnings, in depression it may
maintain the rate of dividend in that years also by madding up deficit from dividend e"ualiation
fund.
;vi< Ea(9 to #eplace t1e -a(ting A((et( 6enerally depreciation is charged on the assets taking
into consideration the present cost and the life of a particular asset. ,eplacement costs is very
often ignored which increases three to four times of the present price due to rise in the price
level during the expiry of life of existing assets. This makes depreciation funds or replacement
fund insufficient to replace the worn out asset. Under these circumstances, the ploughed back
profits can be utilied to make good the deficiency.
;vii< Ea(9 #etirement of Bon0( or 3e4enture( The undistributed accumulated income can also
be used to redeem the bonds or debentures which relieves a company of the fixed burden of
interest charges.
*/ A3!ANTA.ES TO S"A#E"OL3E#S
i< Safet9 of In)e(tment 7very investors cherishes that his investments should be safest and
the return on the investment should at least constant, if not increasing. The policy of ploughing
back of profits assures that
a. The dividend rate will be rationalied
b. The investments is "uite safe and sound and
c. The company can easily withstand the business cycles and seasonal reactions.
ii< Enc1ante0 Mar,et !alue of S1are By declaring dividend to shareholders at more or less
stable rare or at a higher rate than that of the previous year a company earns repute. The
market value of its shares goes up. #hares holders can take a advantage of the increased
market value by selling their holdings in the open market.
iii< Profit( 49 #etaining t1e S1are( +f shareholders do not like to sell their shares at higher
market price, they can retain shares. They may be benefited by the increased earning capacity
of the company as the actual value of their shares will be higher.
iv< "ig1er ollateral !alue The increased value of shares enables the shareholders to borrow
BSPATIL G1
the amount against the securities of such shares on better term. Thus they are treated as
collateral securities for loan.
v< Super Ta> #ection 12= of the +ncome ? tax )ct provides no super tax to the shareholders of
closely ? held companies being owned by a few shareholders. This section provides safeguard
against the practice of ploughing back of profits in closely'held companies.
+/ A3!ANTA.ES TO T"E OUNT#= O# NATION
i< Ai0 in apital Formation( The corporate savings are one of the important means of capital
formation which is very important for the economic prosperity of an underdeveloped country.
Karious new pro$ects in the industrial or other spheres are commenced which would otherwise
remain unexpected because of shortage of finance. Thus ploughing back of profits indirectly
stimulates the rapid industrialiation.
ii< Smoot1 an0 ontinuou( Pro0uction 7very nation is interested in the smooth and
continuous functioning of the old and new enterprises. 4orporate savings provide the stability
and flexibility which are indispensable for the successful operations of companies without which
the industrials mortality rate is likely to be higher.
iii< Buic,7Financing of #ationaliAation Sc1eme( 4orporate savings or a accumulated profits
provide an assurance to the management for "uick implementation of rationaliation schemes
like expansion of industrial activity and improvement of the existing units, such schemes may be
put off or delayed in the absence of retained profits.
iv< .reater; Better an0 1eaper Pro0uction 7 +nternal financing provides an easy finance for
rationaliation, moderniation and automation schemes without any legal formality and charge
on profits. +t facilitates greater and better production at cheaper rates to society which will
increase its standard of living. +n the long run the policy of retained profits goes to increase the
standard of living of the masses.
3ISA3!ANTA.ES OF PLOU."IN. BA8 OF P#OFITS
1. Mi(u(e of Sa)ing( +f the corporate savings are not utilied in the lager interest of shareholders
the management may use them in weaker units under the same management and ownership or in
their pet concerns or in which the shareholders may be least interested.
0. reation of Monopolie( The ploughing back of profits serves vested interests. 4arried to its
logical conclusion, it may tend to create monopolies because as a result of reinvestment of their
profits into their own enterprise the existing companies may grow more and more while new
concerns would find it difficult to raise the capital they need.
8. Manipulation in t1e )alue of S1are( The enormous accumulated earnings provide a greater
scope to the management for manipulation in the value of shares by manipulation the rate of
dividend. )s the rate of dividend to be declared is the sole authority of the board of directors it
cannot be increased even by all the shareholders in the general meeting. .ith an intention to bring
down the market price of shares and purchase them at lower market price, the directors may
declare a lower rate of dividend. +n the subse"uent year, of rate of dividend may be increased out of
the past accumulated profits to raise the market value of shares with an intention to dispose of their
holdings at such increased price. +gnorant shareholder may fall a prey to these tactics and
fraudulent practices of the management.
=. O)er apitaliAation The accumulated reserves may lead over ? capitaliation because the
BSPATIL 12
management may be inclined to capitalie its reserves by issue of bonus shares which will reduce
the rate of dividend.
3. Interference :it1 t1e Free0om of In)e(tor( )n excessive cautious dividend policy refers with
the freedom of the investors whether the management wants that old industry should expand or
they should finance the setting up of a new concern.
C. Social -a(te 7xcessive ploughing back profits entails social waste because money is not made
available to those who can use it to the best advantage of the community, but is retained by those
who have earned it.
D. 3i((ati(faction among S1are1ol0er( )n over'enthusiastic policy of ploughing back of profits
may create dissatisfaction among the shareholders because they think that the management is
damaging their interest by retaining the profits and thus paying a lower rate of dividend that may be
paid out of the available profits. Aost of the shareholders are not happy with this policy.
The analysis of the merits and demerits of the policy of ploughing back of profits, makes it clear that
it is undoubtedly a good policy for the development of the industry but the management should be
cautious and bold enough in carrying out the policy.
INTE#NAL FINANIN.
) new company has only external sources finance. !owever, an existing company can also
generate finance through its internal source. The two most important source of internal financing are
depreciation and retained earnings. 7ach of these internal sources of financing are explained below.
1/ 3epreciation a( a (ource of finance
Depreciation means decrease in the value of assets due to wear and tear, lapse of time, obsolescence,
exhaustion and accident. There is a lot of controversy among academicians and business executives
regarding treatment of depreciation as a source of funds. (eople who oppose treating depreciation as a
source of finance argue that funds are generated by operating profits and not by making provision for
depreciation. +f depreciation were really a source of finance by itself any enterprise could have
improved its position at will by increasing the periodical depreciation charge. They further argue that the
depreciation being a non'cash item of expense does not affect the working capital of the firm and as
such not at all a source of finance.
Kalidity of the above arguments cannot be "uestioned, but it can also not to be denied that as a non'
cash expense, depreciation does not represent any cash outlay with the result that a part of the profits
ad$usted for depreciation can be used by management to increase any of the current assets or pay
taxes, dividend etc. Depreciation may, therefore, can be taken as a source of funds in a limited sense
because of the following reasons.'
;i< Depreciation finds its way into current assets through charging of overheads ;including
depreciation<. The value of closing inventory may include depreciation of fixed assets as an
element of cost.
;ii< Depreciation does not generate funds but it definitely saves funds. %or example, if the
business had taken the fixed asset on hire, it would have been re"uired to pay rent for them.
#ince, it owns fixed assets, it saves outflow of funds which would have otherwise gone out in
the form of rent.
;iii< Depreciation reduces taxable income and, therefore, income'tax liability for the period is
reduces. This will be clear with the following example*
BSPATIL 11
a(e I a(e II
#(/ #(/
+ncome before depreciation D3,222 D3,222
Depreciation +ncome 5il. 13,222
Taxable +ncome D3,222 C2,222
+ncome Tax say at 32M 8D,322 82,222
5et +ncome after tax ;B< 8D,322 82,222
5et %low of funds after tax ;)< L ;B< 8D,322 =3,222
The above example shows that in 4ase ++, the net flow of funds is more by ,s. D,322 as compared to 4ase
+. This is because on account of depreciation charge being claimed as in expense, tax liability has been
reduced by ,s. D,322 in 4ase ++. +t may, therefore, by said that true funds flow from depreciation is the
opportunity of saving cash outflow through taxation.
*/ Financing t1roug1 retaine0 earning(
This is strictly not a method of raising finance but refers to accumulation of profits by a company to
finance its development activities or repay loans. +t is also known as E+nternal %inancingF or
Eploughing back of profitsF. )ccording to the latest provision of the 4ompanies )ct, a certain
percentage, as prescribed by the 4entral 6overnment ;not exceeding 12M< of the net profit tax of a
financial year have to be compulsorily transferred to reserves by a company before declaring
dividends for the year.
Merit( This method of raising finance for a company is very useful because on the one hand it does
not cost anything to the company and on the other hand it strengthens the financial position of the
company. The chief merits of this method of financing can be put as follows*
;i< +t enhances business reputation and increases the capacity of the business to absorb
unexpected and sudden business shocks too.
;ii< )s compared to other sources of financing, this method of financing is least costly since it does
not invoice any floating cost as is the case with raising of funds by issuing different types of
securities. &f course, it may not be wholly correct to say that retained earnings have no cost to
the company. )s a matter of fact, the cost of retained earnings is the return which the
shareholders could have earned on the amount of retained earnings if it had been distributed.
;iii< This method of financing has been broadly found to be useful for financing expansion and
improvements.
;iv< This source of financing is also useful since it carries no fixed obligation regarding payment of
dividend or interest.
3emerit( %inancing through retained earning is not free from evils or misuse. The demerits as
conse"uences of such misuse can be summaried as follows*
;i< The retained earnings can be misused by the management to manipulate the value of the
company-s shares in the stock exchange and also to cover their inefficiency in managing the
BSPATIL 10
affairs of the company.
;ii< 7xcessive use of retained earnings continuously for long period may result in converting the
company into a monopolistic organisation.
;iii< The method of financing through retained earnings may prove harmful to social interest also.
The retained earnings are utilied by individual business units and the society does not get the
chance of investing them through capital market into such business units which may be more
useful to the society.
;iv< The shareholders may also ob$ect to the use of retained earnings as a source of finance since it
affects their regular income. This is particularly true for shareholders falling in lower income
groups.
The "uantum of retained earnings is affected to a great extent by the dividend policy pursued by a firm.
The higher dividend rate means less retained earnings and vice versa.
UNIT !II
SOU#ES OF FINANE
LOAN FINANIN.
) firm may meet its financial re"uirements by taking both short'term loans H credits and long'term loans.
1/ S"OT7TE#M LOANS I #E3ITS
The short'term loans H credits are obtained for working capital re"uirements. The following are the
important sources of short'term loans H credit.
;1< Tra0e re0it Trade credit is a form of short'term financing common to almost all types of
business firms. )s a matter of fact, it is the largest source of short'term funds. +n an advanced
economy, most buyers are not re"uired to pay for goods on delivery. They are allowed a short'term
credit period before payment is due. This credit may take the form of ;a< )n &pen )ccount 4redit
)rrangement ;b< )cceptance 4redit )rrangement.
+n case of an &pen )ccount 4redit )rrangement, the buyer does not sign a formal debt instrument as an
evidence of the amount due by him to the seller. .hile in case of an )cceptance 4redit )rrangement the
buyer accepts a bill of exchange or gives a promissory note for the amount due by him to the seller. Thus,
it is an arrangement by which the indebtedness of the buyer is recognied formally.
BSPATIL 18
Trade 4redit )rrangement is generally made available to the buyer on an informal basis without creating
any charge on assets. Trade 4redit )rrangement usually carry stipulation of allowing a cash discount to the
buyer for prompt payment. The volume of trade credit and its popularity as a means of short'term financing
depends on the following factors.
;i< The terms of trade credit, ;ii< ,eputation of the purchasing firm, ;iii< %inancial position of the
seller, and ;iv< Kolume of purchase to be made by the buyer.
Merit( of tra0e cre0it
;i< The ma$or merit of trade credit as a source of finance is its ready availability.
;ii< Trade 4redit is available on a continuing and informal basis. There is no need to arrange
financing formally. +n case, the firm is not taking cash discounts, additional credit is readily
available by not paying existing trade creditors till the expiry of the credit period. There is no
need to negative with the supplier. The decision is entirely up to the firm.
;iii< There is no need of creating any sort of charge against firm-s assets for obtaining the trade
credit.
;iv< Trade 4redit is a flexible means of financing since the firm does not have to sing a note,
pledge securities or adhere to strict payment schedule. ) seller views occasional late
payment with a far less critical eye than a banker or any other lender.
3emerit( of Tra0e re0it
;i< The cost of trade credit may be very high in case all factors are considered. The seller while
fixing the selling price of his products to be sold on credit takes into account the interest, the risk
and inconvenience attached with supplying goods on credit. )s a matter of a fact, many firms
utilie other sources of short'term financing in order to enable them to take advantage of cash
discount.
;ii< )vailability of liberal trade credit facilities may induce a firm to over trading which may later
prove to be disastrous for the firm.
The firm must balance the advantages of trade credit as a discretionary source of financing without any
explicit cost against the cost of losing of cash discount, the possibility of deterioration in reputation, if
trade credit is stretched beyond agreed limits and the increased purchase price of the product.
*/ ommercial Ban,(
4ommercial banks in our country mostly provide only short'term credit to the business. They have
started providing medium term finance also, but only marginally.
4ommercial banks make advances to the customers in the following forms*
;i< )oans * ) loan is a kind of advance made with or without security. +n the case of loan the banker
makes a lump sum payment to the borrower or credits his deposit account with the money
advanced. +t is given for a fixed period at an agreed rate of interest. ,epayments may be made
BSPATIL 1=
in installments or at the expiry of a certain period. The customer has to pay interest on the total
amount advanced whether he withdraws the money from his account ;credited with the loan< or
not. ) loan once repaid in full or in part cannot be drawn again by the borrower unless the
banker sanctions a fresh loan.
The rate of interest charged by a bank in the case of loans is usually lower than in case of cash credits
and overdrafts on account of the following reasons *
;a< +t involves lower cost of maintenance on account of not fre"uent operation of the account.
;b< The bank gets interest on the total amount sanctioned whether the customer withdrawals the whole
money or not.
Boan may be a >term loan- or a >demand loan-. (ayment of term loan is spread over a long period. +t
includes a medium ? term loan ;repayable< within 1to 3 years< and a long'term loan ;repayable after 3
years<. Demand loan is payable on demand. Thus, it is for a short period.
;ii< +ash +redits * ) cash credit is an arrangement by which a banker allows his customer to
borrow money up to a certain limit. 4ash credit arrangements are usually made against the
security of commodities hypothecated or pledged with the bank.
;iii< ,ypothecation * +n case hypothecation the possession of good is not given to the bank. The
goods remain at the disposal and in the godown of the borrower. The bank is given access to
goods, whenever it so desires. The borrower furnishes periodical return of stock to the bank.
#uch an advance is granted by the bank only to persons in whose integrity it has full
confidence.
;iv< !ledge * +n the case of pledge, the goods are placed in custody of the bank with its name on the
godown where they are stored. The borrower has no right to deal with them.
4ustomers favour hypothecation to pledge because the latter is considered to lower this prestige.
4ash credits are the most favorite mode of borrowing by large commercial and industrial concerns in +ndia,
on account of the advantage that a customer need not borrow at once the whole of the amount he is likely
to re"uire, but draw such amounts as and when re"uired. !e can put back any surplus amount which he
may find with him for the time being. +nterest on a cash credit account has to be paid only on the amount
actually drawn at any time and not on the full amount of the credit allowed. +n order to safeguard the bank-s
interest on a account of banker-s locking of funds unnecessarily because of customer-s drawing funds
much less than the bank-s estimate, a minimum interest clause is often inserted in the cash credit
agreements. The clause re"uires the customer to pay interest to the bank on a certain proportion of
amount arranged for, say, one third, one'fourth, even though he may not have drawn to this extent.
;v< -verdrafts * The customer may be allowed to overdraw his current account, with or without
security if he re"uires temporary accommodation. This arrangement, like the cash credit, is
advantageous from the customer-s point of view as he is re"uired to pay interest on the actual
amount used by him. ) cash credit differs from an overdraft in the sense that the former is used
for long terms by commercial and industrial concerns doing regular business, while the latter is
supposed to be a form of bank credit to be made use of occasionally and for shorter durations.
;vi< Bills discounted and purchased * The banks also give advances to their customers by
discounting their bills. The net amount after deducting the amount of discount is credited to the
account of the customer. The bank mayh discount the bills with or without security from the
debtor in addition to the personal security of one or more persons already liable on the bill.
BSPATIL 13
The term Ediscounting of billsF is used in respect of time bills while the term Epurchasing of billsF is used
in respect of demand bills.
Merit(H
1. #hort'term credit from commercial banks is generally cheaper as compared to any other source of
short'term finance.
0. 4ommercially banks, as explained above, have different schemes of financing thereby considerably
flexibility can be maintained.
8. 4ommercial banks also provide credit to trade and industry at concessional rates under their
special schemes as per the directives of the ,eserve Bank of +ndia.
=. 4ommercial banks also act as friend, philosopher and guide to their client business firms in respect
of the new ventures to be taken up and the most appropriate sources from which finances have to
be raised by them.
3emerit( H
;i< %inancing from commercial banks re"uires signing of a number of documents involving cost as
well as time.
;ii< 4ommercial banks rarely grant unsecured credit to business firms. This acts as deterrent for the
firms to depend more on commercial banks for their financial re"uirements.
;iii< ) commercial bank takes a very critical view of even a small irregularity committed by its
customer in respect of the operation of his account.
+/ Pu4lic 3epo(it(
Aany companies accept deposits for short periods from their members, directors and general public. This
mode of raising funds is becoming popular these days on account of bank credit becoming "uite costlier.
)ccording to the existing provisions, a company cannot accept deposits for a period of less than C months
and more than 8C months. The maximum rate of interest on public deposits depends as ,B+ directives.
!owever deposits up to 12M of the paid up capital and free reserves can be accepted for a minimum
period of three months for meeting short term re"uirements. Aoreover, a company cannot accept or renew
deposits in excess of 83M of its paid'up capital and free reserves.
Merit(
;i< %inancing through deposit is simple without much of complicated formalities involved. The
company has simply to advertise and inform the public that it is interested in and authoried to
accept public deposits.
;ii< +t is a less costly method for raising short term as well as medium term funds re"uired by the
business.
;iii< There is no need of creation of any charge against any of the assets of the company for raising
funds through public deposits.
;iv< The company can take advantage of trading on e"uity since the rate of interest and the period
for which the public deposits have been accepted are fixed.
3emerit(
;i< ,aising funds through public deposits is not a reliable and definite source of finance. )
BSPATIL 1C
company en$oying good reputation in the market is in a positions to raise sufficient funds
through public deposits. !owever, companies which do not en$oy such reputation cannot raise
sufficient funds by this method. Aore ever, in a period of depression and financial stringency
this source will dry up.
;ii< This mode of financing sometimes puts the company into serious financial difficulties. 7ven a
slight rumour that the company is not doing well may result in a rush of the public to the
company for getting premature payments of the deposits made by them.
;iii< The system may prove in$urious for the growth of a healthy capital market. ) heavy reliance on
public deposit for medium ? term financing by companies may adversely affect the supply of
industrial securities, particularly shares and debentures to general public.
5/ Finance ompanie(
During the last ten years finance companies have assumed an important role in providing and arranging
finances for the industry in the following manner.
1. )easing and ,ire !urchase * %inance 4ompanies help industry in ac"uisition of capital assets vi.
(lant and Aachinery, Kehicles, &ffice 7"uipments through leasing or hire purchase facilities. Today
leasing and hire purchase are so prevalent as a mode of financing that have become sale aid tools
for the automobile and consumer electronics industry.
0. .erchant Baning * .ith the liberaliation of the capital market system and abolition of office of the
4ontroller of 4apital +ssues, it has become very attractive for the companies to raise long term
financial resources through capital market rather than depending on finances from financial
institutions and banks. %inance companies help the industry in this process by providing the
merchant banking services.
Aerchant banking is basically a service banking, concerned with providing non'fund based services of
arranging funds rather than providing them. The merchant banker merely acts as an intermediary, whose
main $ob is to transfer capital from those who own it to those who need it. .ith the increase in the
complexities and re"uirements of modern business, the role of a merchant banker has undergone
substantial change. The merchant banker now acts as an institution which understands the re"uirements of
the entrepreneur-s promoters on the one hand and financial institution, banks stock exchanges and money
markets on the other. The services of a merchant banker can be summaried as follows*
;1< !ro/ect counselling * ) merchant banker helps an entrepreneur in conception of idea, identification
of pro$ects, preparation of pro$ects feasibility reports, fixing location, obtaining money, sanctions H
approvals from #tate and 4entral 6overnment departments.
;0< %ponsor of issue* Aerchant bankers act as sponsor of issue rather than sources of finance. They
prepare prospectus, get the approval from #7B+. 7ngage underwriters, brokers and bankers for
issue.
;8< +redit syndication* Aerchant bankers undertake preparation of pro$ect files, loan applications for
financial assistance on behalf of poromoter from different financial institution for meetings long'term
as well as working capital re"uirements of their clients.
;=< %ervicing of issues * Aerchant bankers keep register of share holders and debentures holders of
their client ? companies, act as paying agents for the dividends, debentures interest. They also
arrange for safe custody of securities on behalf of their clients.
BSPATIL 1D
;3< 0nvestment management * Aerchant bankers render advice in matters pertaining to investment
decisions, effects on taxation and inflation of giltedged and other securities. They also undertake
the functions of buying and selling securities for their client companies.
;C< 1rrangement for fi2ed deposit * Aerchant bankers help companies to raise finance by way or
deposits from the public. %or this purpose, they not only provide re"uired guidance but also acts as
brokers for mobiliation of public deposits.
;D< -ther specialist activities * These include*
a. 4orporate counselling for financial institutions, rehabilitation and reconstruction of oldHailing
or sick industrial units.
b. #ervices to 5,+s for suitable investment opportunity in +ndia.
c. )ssistance in negotiations of foreign collaboration.
d. )rranging technology, finance and risk H venture capital.
#uitable fee is charged for such services by the bankers. The amount of fee will depend on the width and
range of services rendered.
+n order to function as a merchant banker, one has to take authoriation from the securities Q exchange
Board of +ndia ;#7B+<.
)s at the end of )ugust, 11G=, the total number of merchant bankers ;of all categories< registered with
#7B+ was =00.
8. "quity #esearch and 0nvestment +ounselling * ) common investor is not able to apply his mind for
analysis of financial statement and future prospects of various companies for investment decisions.
+n order to cater to the needs of such investors, many finance companies have established e"uity
research and investment counselling department. The department provides advisory services to
potential investors at a nominal cost and thus indirectly help the companies to raise resources.
6/ Accrual Account(
)ccrual accounts are a spontaneous source of financing, since they are self generating. The most
common accrual accounts are wages and taxes. +n both cases the amount becomes due but is not
paid immediately. Usually a date is fixed for payment, for example, wages are paid in the first week
of the month next ot the month in which the services were rendered. #imilarly, a provision for tax is
created out of the profits of the company at the end of the financial year but the tax is paid only after
the assessment is finalied. Thus, the time lag between receipt of income and making payment for
the expenditure incurred in earning that income helps the business in meeting some of its short'
term financial re"uirements. )ccrual accounts become an important source of finance since with
increase in scope of the operation of the business with increase in sales, labour cost usually
increase and with them the amount of accrued wages also increase. #imilarly with increasing profits
the amount of accrued taxes also increases in almost in the same proportion and in the same
direction.
Merit(
%inancing through accruals is a costless or interest free source of financing. #ervices are rendered by the
employees but they are not paid not they expect to be paid until the end of the pay period. #imilarly taxes
re not paid until their due date.
BSPATIL 1G
3emerit(
)n accrual account is not discretionary sources of financing@ for example, the company cannot indefinitely
postpone the payment of taxes of the 6overnment without attracting penalties. #imilarly the trade unions
will also resent if the wages are not paid to the workers in time. (ostponement of wages may also affect
the morale of the employee resulting in absenteeism reducing efficiency and higher labour turnover.
This source of financing should be resorted to only in the last. !owever, many companies on the brink of
cash insolvency find it a convenient remedy to save themselves by resorting to postponing payment of
wages and other expenses.
D/ In0igenou( Ban,er(
+ndigenous bankers are private individual engaged in the business of financing small and local business
units. They provides short'term or medium'term finance. !owever, they charge exorbitant rates of interest
and are, therefore, considered only as a lat resort of finance.
J/ A0)ance( from u(tomer(
Aanufacturers and contractors engaged in producing or constructing costly good involve considerable
length of manufacturing or construction time usually demand advance money from their customers at the
time of accepting their orders for executing their contracts or supplying the goods. This is a cost'free
source of finance and really useful in those businesses where it has become customary to receive advance
payment from the customers.
G/ Mi(cellaneou( Source(
) business firm may resort to miscellaneous sources of finance in periods of pressing needs. #uch sources
may include loan from directors or sister business units. #pecialied financial institutions also provide
short'term finance to their client units in times of need. The cost of these funds is usually nominal.
*/ LON. TE#M O# TE#M LOANS
The term ETerm BoansF is used for both medium as well as long'term loans. Aedium terms loans are for
periods ranging from 1 to 3 years while long'term loans are for a period from 3 to 12 years. %irst the special
features of such loans and then the role played by different institutions in granting of such loans are
discusses.
Special feature( of term loan(
1. O4?ecti)e The term loans are granted for one or more of the following ob$ectives*
;a< 7stablishment, renovation, expansion and moderniation of industrial units.
;b< %or meeting the re"uirements of the core working capital.
;c< %or retiring bonds in order to reduce interest costs or to redeem preference shares so as to
substitute tax deductible interest payment for non'deductible dividends.
0. Securit9 Terms loans are usually secured. They have either a fixed or floating charge against the
assets of the company. The lender bank usually prefers a first charge, however, in appropriate
BSPATIL 11
cases it accepts a second charge also.
8. Time perio0 The term loans are granted for a period ranging from 1 to 13 years but generally
from G to 13 years. The repayment is made in installments typically designed to fit the pro$ect
capacity of the borrower to pay. The repayment starts 0 or 8 years after sanctioning of loan. The
lending institution re"uires payment only in accordance with the specified schedule so long the
borrower carries out his commitments under the loan agreement. +n case of default in such
commitment, the agreement provides for accelerating of the maturity of the loan.
=. Formal agreement The term loan is granted on the basis of a formal agreement. The agreement
contains the terms of granting loan and provides for certain protective clauses for the benefit of the
lender, e.g. limiting the dividend rate, the power to appoint directors, conversion of loan into share
capital, etc. Then terms are settled through direct negotiation between the borrower and the lending
institutions.
3. Participation 4a(i(7 +n case of term'loan being a substantial amount, different financial institutions
participate in the credit on a syndicated basis. #uch participation is done either because restrictions
or for sharing the risk. The larger the loan, greater is the participation.
C. Intro0uce( financial 0i(cipline Term loans introduce a proper financial discipline in the
borrower. !e has to forecast reasonable accuracy cash flows so that he can repay loan and interest
as per the agreed schedule. This makes necessary for the borrower to prepare a pro$ected cash
flow statement.
D. #efinance facilit9 4ommercial banks are granted refinance facility from +ndustrial Development
Bank of +ndia on the terms loans granted by them. The risk, of course, continues of the lending
commercial bank.
G. Pro?ect oriente0 approac1 %inancial institution engaged in term lending do not do security'
oriented lending any longer. They have detailed app of each pro$ect and asserts its own merits. The
loan is sanctioned only when the pro$ect satisfies their tests.
1. Special on0ition( +n order to provide safeguards against time and cost overruns the loan
agreements usually re"uire the borrower to give undertaking in respect of the following matters *
;i< 5o further long'term loan shall be taken
;ii< The debt'e"uity ratio will not exceed the specified limit.
;iii< 4urrent ratio will be maintained at the desired level.
;iv< #elling commission sole selling agent shall not be disbursed unless interest and installments of
loans are paid.
;v< Dividend shall not be declared for a specific period or shall not exceed the agreed rate.
;vi< %inancial data and other information as re"uired by the lending institution will be supplied as
and when desired.
;vii< The directors will furnish personal guarantees for repayment of the loan in addition to the
financial institution-s charge on firm-s assets.
Source( of Term Loan(
There are two ma$or sources of term loan * ;i< #pecified financial institutions or development banks and ;ii<
4ommercial banks. !owever, the former happens to be the main source of term'finance for all business
and industrial units. 7ach of these sources of finance have been explained in the following pages.
BSPATIL 122
Source( of Term Finance
The ma$or sources of term finance in +ndia are as follows *
;1< Term Loan( ) term loan is a business loan with a maturity of more than one year. There are
exceptions to the rule, but ordinarily term loans are retained by systemic repayments over the life of
the loan. The primary lenders on term credit are 4ommercial banks, life insurance corporation,
financial institutions, general insurance companies, investment trusts and state and central
government. 4ommercial banks and various financial institutions constitute the hard core of term
financing in +ndia. Term lending business of 4ommercial banks is recent innovation in +ndia
specially after 113G. +t was in the year of 113G only when a formal scheme of term loans was
started. But, now'a'days these banks provide a larger share of tem finance to +ndian +ndustries.
;0< Pu4lic 3epo(it Besides, commercial banks and institutional finance, the public deposits are also
important source of term finance. Till independence, this system was prevalent mainly in the cotton
textile industry of Bombay, )hmedabad, and to some extent, that of #holapur, and the tea gardens
of )ssam and Bengal. But now'a'days this system has been very popular with all types of
companies and business. +n January D3 the ,eserve Bank of +ndia issued news guidelines
regarding public deposits, since then, the method has gained more popularity. By renewal or getting
initial deposits for 8 or 3 years at a lucrative rate of interest N 10M ' 13M, the companies have
been able to attract a large section of individual-s savings towards them.
;8< on0itional Sale( ontract( This system is also known as hire ? purchase or installment
purchasing system. Under this method, the industrial purchases machinery at deferred payment
basis. #ome part of the price is paid at once at the time of delivery ;it is known as cash'down
payment< and remaining part of the purchase price is paid in installments through a finance
company or a bank. %actory e"uipments hotel and restaurant fixtures, buses, tractors, and trailer,
medical e"uipments etc. are supplied by their manufactures generally on this basis. #uch
conditional sale contact may be signed by the manufacturer and purchase of machinery and bank
can guarantee this payment. #ometimes, bank or financial institution becomes a party to this
contract.
;=< Lea(e Financing Business firms are generally interested in using fixed assets, not in owing
them, but on the basis of lease arrangement. Before 1132-s lease system was particular with land,
buildings and mining only@ but now it is possible to lease virtually all kinds of fixed assets today. )
lease contract takes several different forms, the most important of which are sale and leaseback,
service leases, and straight financial leases. Beasing has the advantages of a smaller down
payment and increased opportunities for tax savings, and it increases the over all availability of
non'e"uity financing to the firm.
;3< Internal Source( of Term Finance ) company does not go in for external sources of funds
every time. But internal sources of funds are also used by them. ,etained earnings, employee-s
provident fund and pension fund accumulations, provisions for depreciation etc. also constitute and
important source of internal term financing. These funds can be successfully utilied by the
companies for replacement, obsolescence, short'term expansion or medium'term financial
re"uirements. During the last five years in +ndia, the business firms are relying upon internal
sources more due to credit's"ueee by commercial banks and specially after the submission of
Tandon 4ommittee ,eport.
Term Len0ing
BSPATIL 121
The primary task of a lending institution before granting a term loan is to assure itself that the anticipated
rise in the income of the borrowing units would materialie, thus providing the necessary funds for
repayment. The methods of analysis and appraisal of a term loan applications and standards to be adopted
for it are more similar to investment decision that to short'term lending. )ppraisal of term'loan application
re"uires a dynamic approach involving inter'alia, a portion of future trends of output, sales, estimates of
costs, returns and flow in analying a term'loan proposal, emphasis is generally placed on the following *'
;1< Type and sie of Business.
;0< The ,ecord, character and continuity of Aanagement
;8< 6eneral ,ecord of the borrower ;in respect of his product market, competition and general outlook
for that industry etc.<
;=< &perating 7fficiency
;3< %inancial conditions and pro$ected balance'sheet etc.
;C< 7stimations of future 7arnings and cashflows.
;D< The available security
+n +ndia, when an application for term loan is moved to a term lending institution, the borrower is re"uired to
submit the following statement and papers along with the application *
;i< Brief historical background of the pro$ect or plant.
;ii< Details of promoters, if it is a new company.
;iii< Batest audited Balance #heet in case of an existing company.
;iv< 7xisting manufacturing facilities.
;v< ) pro$ect feasibility ,eport
;vi< 4apacity calculations must be submitted separately in terms of 822 working days.
;vii< Aanagement set'up and particulars regarding management people.
;viii< (romoter-s contribution to the (ro$ect cost ? normally it is acceptable upto 02M but relaxation is
possible for backward area locations, technical entrepreneur-s pro$ects and capital ? intensive
pro$ects. But their contribution in any case shall not be less than 13M.
;ix< The following annexures are a must with the application.
;1< 4opy of letter addressed to the bankers authoriing them to disclose any information concerning
the applicant.
;0< (articulars of existing long'term borrowings.
;8< (articulars of existing shareholdings.
;=< Distribution of existing shareholders.
;3< (articulars of proposed buildings.
;C< (articulars of proposed machinery.
;D< (articulars of imported machinery.
BSPATIL 120
;G< ,aw material re"uirements.
;1< 7stimates of the cost of pro$ect.
;12< 4alculation of contingency
;11< 4alculation of margin money for working capital.
;10< Aeans of %inancing
;18< (roposal for raising share capital loans and debentures
;1=< #ources of funds in respect of expenditure already incurred.
;13< 7stimates of cost of capital.
;1C< 7stimates of cost of production
;1D< 7stimates of working capital
;1G< 7stimates of production and sales.
;11< 4alculation of amount of wages and salaries at optimum production level.
;02< 4ashflow statements.
;01< (ro$ected Balance #heet
;00< Break'even charts.
.hen an application is received by the financial institution its term lending section makes an appraisal of
the proposed pro$ect thoroughly. 7ach pro$ects is assessed on its own merits. The declared ob$ective of
such appraisal are threefold*
;1< The %inancial Kalidity
;0< The 7conomic necessity ;from the national economy point of view<
;8< The Technical %easibility
&nce the ob$ectives are fixed, appraisal is $ust an intelligent application of the techni"ues of appraisal.
SpecialiAe0 Financial In(titution( or 3e)elopment Ban,(
) large numbers of specialied financial institutions have been set up in the country after independence to
meet the specific term financial needs of industrial enterprises. They are popularly known as EDevelopment
BanksF. ) development bank is essentially Ea development catalystF. +t seeks to mobilie scarce resources,
such as capital, technology, entrepreneurial and managerial talents and channelie them into industrial
activities in accordance with plan priorities. +t has, therefore, to shape its policies, procedures, and
functions in a way so as to cater to development needs of specific sectors as well as the economy in
general. #ome of such banks are as follows*
1/ In0u(trial Finance orporation of In0ia &IFI'
The corporation was set up in 11G= under an )ct of (arliament to provide medium and long'term
financial assistance to industry. The 4orporation can grant such assistance only to public limited
companies and co'operative societies. #tate'owned public limited companies can also obtain
assistance from the 4orporation as per an announcement made by the 4orporation in )ugust 11D2.
BSPATIL 128
The corporation has been converted into a limited company from July 1118.
#e(ource( of IFI The original authoried capital of the 4orporation was ,s. 02 crores. +t was
increased to ,s. 122 crores by an amendment in 11G0. +n 11GC by another amendment, it has been
provided that the share capital of the 4orporation can be raised to ,s. 032 crores as may be fixed by
the 4entral 6overnment by notification from time to time. The paid'up share capital as on 81
st
Aarch,
1111, was ,s. 183 crores. The 4orporation can also accept deposits from the public and borrow money
from ,B+ for augmenting its resources.
Management * The management of the 4orporation vests in a Board of Directors appointed as follows*
5o. of directors
5ominated by 4entral
6overnment
8
5ominal by ,eserve Bank 8
7lected by Bank, +nsurance 4ompanies, +nvestment C
Total 10
The Board of Directors have delegated their powers to a committee of directors considering of five
member, one of whom is the Aanaging Director of the 4orporation.
Function( The functions of the 4orporation as given in the )ct are as follows'
;i< 6uaranteeing loans raised by industrial concerns which are repayable with in a period not
exceeding 03 years and are floated in the public market.
;ii< Underwriting of the issue of stocks, shares, bonds or debentures issued by industrial concerns.
!owever, they must be disposed of by the corporation within D years of their ac"uisition.
;iii< 6ranting loans or advances to or subscribing to debentures of industrial concerns repayable
within a period not exceeding 03 years.
;iv< 7xtending guarantee in respect of deferred payments by importers who are able to make such
arrangement with foreign manufactures.
;v< )cting as the agent of the 4entral 6overnment or for .orld Bank in respect of loans sanctioned
to the industrial concern.
;vi< Undertaking financing of pro$ects wit the +ndustrial Development Bank of +ndia and other
financial institutions. Those would include guaranteeing loans raised by industrial concerns from
other financial institutions, the purchase of stock, shares, bonds and debentures from existing
holders, doing merchant banking operations, undertaking research to carry out techno'
economic studies in connection with industrial development etc.
The 4orporation provides financial assistance for setting up new industrial pro$ects, renovation,
moderniation, expansion, diversification of existing ones. +t also provided financial assistance on
concessional terms for setting up industrial pro$ects in industrially less developed districts in the #tate and
Union Territories as may be notified by the 4entral 6overnment.
-or,ing of t1e orporation 7ver since its inception in 11=G till the end of Aarch 111C, the total
sanctions and disbursements by +%4+ amounted to ,s. 88,C13 crores and ,s. 11,132 crores respectively.
BSPATIL 12=
)s at the end of Aarch 111C total outstanding assistance stood at ,s. 10,D31 crores.

*/ State Financial orporation
+n order to provide financial assistance to small'scale industries and medium sie industries, #tate
%inance 4orporation )ct was passed by (arliament in 1131. The act is applicable to all #tates except
the #tate of Jammu and :ashmir. )lmost all the #tates have set up such 4orporation.
The capital of such corporation has to be fixed by the #tate 6overnment with the minimum and
maximum limits of ,s. 32 lakhs to ,s. 32 crores. The shares of the corporations are taken by
respective #tate 6overnment, the ,eserve Bank of +ndia, scheduled banks, co'operative banks,
insurance companies, investment trust and private parties. The maximum allotment to private parties
cannot exceed 03M of the share capital of the corporation. The corporation can grant assistance
maximum assistance to a company H co'operative society that would not exceed ,s. C2 lakhs and to a
partnership or a sole proprietary firm ,s. 82 lakhs..orking ? The total assistance granted by 1G #tate
%inancial 4orporations ;including Tamilnadu +ndustrial +nvestment 4orporation Btd. < since their
inception amounted ,s. 00,G18 crores and disbursements at ,s. 1D,130 crores as the end of Aarch 81,
111C<
+/ State In0u(trial 3e)elopment orporation &SI3('
#tate +ndustrial Development 4orporation have been set up by different #tate 6overnments for
promoting industrial development in their respective #tates. )s at the end of Aarch 81, 111C 0G #+D4s,
since their inception, had sanctioned and disbursed financial assistance to the extent of ,s. 11,D10
crores and ,s. G,803 crores respectively.
5/ In0u(trial re0it an0 In)e(tment orporation of In0ia &III'
The 4orporation was established on January 3, 1133 to assist industrial enterprises in the private
sector. +t started its operations as a wholly privately owned institution but with nationaliation of the life
insurance business, the Bife +nsurance 4orporation of +ndia has become its ma$or shareholder.
O4?ect(H The ob$ects of the corporation are to assist industrial enterprise in private sector by*
;i< 6ranting secured loans in rupees repayable over a period of 13 years.
;ii< Aaking similar loans in foreign currencies for payment of imported capital e"uipment and
technical service.
;iii< 6uaranteeing rupees payments for credit made by others.
;iv< #ubscribing to e"uity and preference shares directly and underwriting public and private issues
and offer to sale of industrial securities.
;v< %urnishing technical and administrative assistance to +ndian industry.
6/ In0u(trial 3e)elopment Ban, of In0ia &I3BI'
The +DB+ was established in July 11C= under the +ndustrial Development Bank of +ndia, )ct as a wholly
owned subsidiary of the ,eserve Bank of +ndia. !owever, in %ebruary 11DC, it was delinked from the
,eserve Bank and has emerged as an independent organiation. +t now serves as an apex financial
BSPATIL 123
institution.
,esources * The principal resources of +DB+ are * ;i< #hare capital and ,eserves, ;ii< borrowings from
the 6overnment of +ndia and ,B+, ;iii< Aarket borrowings by way of bonds, ;iv< %oreign currency
borrowings, and ;v< ,epayment of past assistance by borrowers.
The Bank-s authoried share capital is ,s. 0,222 crores. The issued and paid up share capital as on
Aarch 81, 111C, of the bank was ,s. G1G.31 crores, largely held by the 4entral 6overnment.
Aanagement ? The +DB+ has a board of directors appointed as follows*
;i< ) chairman and a Aanaging Director both appointed by the 4entral 6overnment. !owever, the
same person may also function as chairman as well as Aanaging Director.
;ii< ) Deputy governor of the ,eserve Bank of +ndia is nominated by it.
;iii< 5ot more than 02 directors nominated by the 4entral 6overnment are as follows*
;a< Two directors who are the official of the 4entral 6overnment.
;b< %ive directors from the financial institutions vi., +4+4+, +%4, +DB+, B+4 Q UT+.
;c< Two directors amongst the employees of +DB+ and the above mentioned financial institutions
? one from the officer employees and the other from workmen employees.
;d< #ix directors from the #tate Bank, nationalied banks and #tate %inancial 4orporation.
;e< %ive directors having special knowledge and professional experience in science,
technology, economics, industrial co'operative, law, industrial finance, investment,
accountancy, marketing or any other matter useful to +DB+.
O4?ecti)e an0 Function( H The main ob$ective of +DB+ is to serve as the apex institution for term'finance
for industry in +ndia.
The Bank ha been assigned a special role in respect of the following matters*
;i< (lanning, promoting and developing industries to fill the gaps in the industrial structure in
+ndia.
;ii< 4oordinating the working of institutions engaged in financing, promoting or developing
industries and assisting in the development of such institutions.
;iii< (roviding technical and administrative assistance for promotion, management or
expansion of industry, and
;iv< Undertaking market and investment research and survey as also techno'economic
studies in connection with development of industry.
The Bank-s charter provides for considerable operational flexibility. +DB+ can finance all types of industries
irrespective of the form of organiation or sie of the unit. )lso there are no restriction on the nature and
type fo security and "uantum of assistance which the Bank can provide.
Sc1eme( of A((i(tance The schemes of assistance operated by the +DB+ can broadly be divided into
two categories, vi., ;i< Direct )ssistance #chemes which include (ro$ect %inance #cheme, Technical
Development and %und #cheme and 7"uipment %inance #cheme, etc. ;ii< +ndirect )ssistance #chemes,
BSPATIL 12C
which includes ,efinance of +ndustrial Boans #cheme, Bills ,ediscounting #cheme, #eed 4apital
)ssitance #cheme and ,esources #upport #cheme.
-or,ing of I3BI The cumulative sanctions by the +DB+ up to 81
st
Aarch, 111C, under its various
schemes, since its inception, amounted to ,s. 1,1=,G11 crores while the disbursements amounted to ,s.
DD,C11 crore. &ut of this direct assistance amounted to about 32.0M of the total sanctions.
The +DB+ has recently decided to provide working capital loans also initially to those companies which have
taken term loan from it. +DB+ has earmarked a sum of ,s. 0,322 crores for 111D'1G for this purpose.
D/ Unit Tru(t of In0ia &UTI'
UT+ came into existence of %ebruary 1, 11C= under the Unit Trust of +ndia )ct, 11C8. +ts establishment has
been a landmark in the history of investment trusts in +ndia.
The initial capital of ,s. 3 crores was subscribed fully by the ,eserve Bank of +ndia ;,s. 0.3 crores<, the
Bife +nsurance 4orporation ;,s. D3 Bakhs<, the #tate Bank of +ndia, ;,s. D3 lakhs<, and scheduled banks
and other financial institutions ;,s. 1 crore<
The general administration and management of UT+ is vested in the Board of Trustees consisting of a
4hairman and nine other Trustees.
The ob$ective of the Unit Trust is to stimulate and pool the savings of the middle andlow income groups
and to enable them to share the benefits and prosperity of the rapidly growing industrialiation of the
country. )s a result of an amendment in the UT+ )ct in 11GC, the UT+ is also assisting corporate sector
through term loans, underwriting direct subscription to shareHdebentures.
The above ob$ective is achieved by the UT+ through a three'fold approach*
;i< By selling units of the Trust to as many investors as possible in the different parts of the country.
;ii< By investing the ale proceeds of the units and also the initial capital fund of ,s. 8 crores in
industrial and corporate securities@ and
;iii< By paying dividends to those who have bought the units of the Trust.
-or,ing H UT+ is playing an important role in mobiliing savings of the community through sale of units
under the various schemes and channeliing them into corporate investments. &ver the years is has
floated 83 schemes including two off'shore country funds to suit diverse investment needs of the investors.
4onse"uent upon amendment to the UT+ )ct, effective from )pril 08, 11GC, UT+ has been extending
assistance to the corporate sector by way of term loans, bills rediscounting, e"uipment leasing and hire'
purchase financing. +n June 1112, UT+ set up the UT+ +nstituted of 4apital Aarkets with a view of promote
advanced professional education, training and research in the fields of capital markets.
)t the end of June 111C, the UT+ had a U5+T capital of ,#. ==,8GC crores and reserves and funds of ,s.
1,1GC crores. The cumulative sanctions and disbursement up to the end of Aarch, 111C, to the corporate
sector, amounted to ,s. =8,80G crores and ,s. 80,011 crores respectively.
J/ In0u(trial #econ(truction Ban, of In0ia &I#BI'
The +ndustrial ,econstruction Bank of +ndia ;+,B+< was established in 11G3 under the +ndustrial
BSPATIL 12D
,econstruction Bank of +ndia )ct. 11G3, after reconstitution of the erstwhile +ndustrial ,econstruction
4orporation of +ndia. +t is the principal credit and reconstruction agency for rehabilitation of sick and closed
industrial units. +t assists industrial concerns by granting loans and advances, underwriting of stocks,
shares, bonds and debentures and guarantees for loansHdeferred payments. The range of its services
includes provision of infrastructural facilities, consultancy, managerial and merchant banking facilities and
making available machine and other e"uipment on lease or hire'purchase basis.
The 4orporation has been converted into a company in January 111D through a (residential &rdinance.
#ince its inception in )pril, 11D1 ;as +#,4< till the end of Aarch, 111C the cumulative sanctions and
disbursements amounted to ,s. 8,301 crores and ,s. 0,=2= crores respectively.
G/ Small In0u(trie( 3e)elopment Ban, of In0ia &SI3BI'
The small +ndustries Development Bank of +ndia ;#+DB+< has been set up under the #mall +ndustries
Development Bank of +ndia )ct, 1112, passed by (arliament. #+DB+ is intended to work as a principal
financial institution for the promotion, financing and development of industries in the small'scale sector. +t is
also expected to coordinate the functions of the financial institutions, vi, #tate %inancial 4orporation, #tate
#mall +ndustries Development 4orporation, #cheduled Banks and #tate 4o'operate Banks, etc. engaged
in the promotion financing and developing the small'scale industries.
#e(ource( The resources of #+DB+ mainly comprise contribution from +ndustrial Development Bank of
+ndia ;+DB+< in the form of loans and shares and may include market borrowings, short'term and long'term
funds from the ,B+ and loans from the 6overnment of +ndia.
The capital of the bank is ,s. 1,222 crores and paid'up capital as on 81
st
Aarch 111C was ,s. =32 crores.
The capital of the bank is wholly subscribed by the +DB+.
-or,ing The #+DB+ commenced operations on )pril 0, 1112, by taking over the outstanding portfolio and
activities of +DB+ pertaining to the ##+ sector. The portfolio thus transferred to #+DB+ aggregated ,s. =,022
crores. The total sanctions and disbursements extended by #+DB+ aggregated ,s. =,022 crores. The total
sanctions and disbursements extended by #+DB+ under its various scheme since its inception upto the end
of Aarch, 111C amounts to ,s. 11,20C crores respectively.
F/ ommercial Ban,(
Term ? bending by commercial banks is a recent phenomenon, +t is felt that the commercial banks could
not afford to lock up large funds in long term assets because it would affect their li"uidity and would make it
difficult for them to meet the working capital needs oft trade and industry. !owever, since 113G, when
,efinance 4orporation as established by ,B+, the ,eserve Bank of +ndia was enger to recommend a
change in the attitude of commercial banks towards term lending because on the one hand it could boost
the profits of the lending banks and on the other hand enable the borrowing units to en$oy certainty of
having funds for a specified period irrespective of any change of the monetary policy. )s a result of this,
the commercial banks have started taking interest in term'lending but on a very nominal scale. +n Aay
BSPATIL 12G
11D3 the ,eserve Bank urged the commercial banks to step up their term'lending particularly in the
following areas.
;i< Deferred export payments.
;ii< +ndustries where a significant portion of the output is meant for export or where new potential for
export could be "uickly built up.
;iii< +ndustries having short gestation period particularly in the core sector and especially those
producing mass consumption goods.
;iv< )gricultural sector.
;v< +ndustries in the +ndustrially backward areas.
;vi< #mall'scale industries involving investment not exceeding ,s. 03,222
;vii< 4apital goods industries.
;viii< Deferred payment arrangements for purchase of capital goods in the domestic market.
4ommercial banks can sanction term loans up to ,s. 32 crores for individual pro$ects. The banking system
as a whole can now sanction term loans up to ,s. 022 crores for an individual pro$ects.
1K/ E>port Import Ban, &E$IM Ban,'
The 7R+A Bank was set up on 1
st
January 11G0, for financing and promoting export and also for
coordinating working of other financial institutions engaged in the export'import financing. The bank
functions as an apex institution for assisting and supporting development of such financial institutions
which are engaged in financing export'import. +t also takes promotional activities and provides counseling
services to persons connected with export import business.
Sc1eme( of A((i(tance The various schemes of 7R+A Bank are as follows*
;i< "2port bill re(discounting scheme * The 7R+A Bank rediscounts exports bills of banks of a
period not exceeding 1G2 days.
;ii< #e(finance of e2port credit * The 7R+A Bank gives 122M refinance in respect of post'shipment
credit extended by bank to exporters for export of capital goods.
;iii< Financial 1ssistance * The 7R+A Bank grants terms loans in rupee to exporters for export of
plants, e"uipments, machinery and related services on deferred payment terms to importers
abroad, turnkey pro$ects and constructions contracts.
;iv< -verseas 0nvestment Finance * The 7R+A Bank finances the e"uity investment by +ndian
promoters in $oint ventures abroad.
;v< 3uarantees 4 The 7R+A Bank participates with commercial banks in the guarantees issued in
foreign currencies on behalf of +ndian exporters, contractors in favour of overseas importers.
;vi< -verseas Buyer5s +redit 4 The 7R+A Bank offers credit directly to the foreign buyers for import
of capital goods and turnkey pro$ects from +ndia.
;vii< 1dvisory %ervices * 7R+A Bank offers advisory services such as advising small scale
manufacturers on export markets and product areas and design financial packages for export'
oriented industries in +ndia.
BSPATIL 121
-or,ing of t1e Ban, H The bank started its operations with effect from Aarch 1, 1S1G0. #oon after its
establishment it took over the export loan and guarantee portfolio of +ndustrial Development Bank of +ndia
;+DB+<. The cumulative sanctions and disbursements as at the end of Aarch 111C amounted to ,s. 1=,88G
crores and ,s. 11,G21 crores respectively.
Important o)enant( incorporate0 in Long7term Loan Agreement
The %inancial +nstitutions while granting long'term loans to borrowers incorporate certain covenants in the
loan agreement to protect their interest. These covenants basically relate to pro$ect implementation, loan
realiation, special bank accounts, changes in contracts, insurance coverage etc. #ome of the important
covenants which are generally incorporated by the lead financial institutions re"uired the borrower as
follows*
;i< !e shall promptly notify the lead institution of any proposed change in the nature or scope of the
pro$ect and of any event or condition which might materially or adversely affect or delay
completion of the pro$ects or result in substantial over'run in the original estimates of costs. any
proposed change in the nature of scope of the pro$ect shall not be implemented or funds
committed therefore without the prior approval of the lead institution.
;ii< !e shall promptly inform the lead institution of the circumstances and conditions which are likely
to disable the borrow implementing the pro$ect or which are likely to delay its completion or
compel the borrowers to abandon the same.
;iii< !e shall furnish to the lead institution such reports as re"uired by the lead institution.
;iv< !e shall obtain prior concurrence of the lead institution to any material modification or
cancellation of the borrower-s agreements with is various suppliers.
;v< !e shall ensure proper maintenance of the property.
;vi< !e shall make alteration in memorandum of association and articles of association as desired
by lender.
;vii< !e shall facilitate appointment of lender-s nominee director.
;viii< !e shall promptly inform the lead institution if it has notice of any application for winding up
having been made or any statutory notice of winding up under the provisions of the 4ompanies
)ct., 113C or any other notice under any other )ct or otherwise of any suit or other legal
process intended to be filled or initiated against the borrower and affecting the title of the
properties of the borrower or if a receiver is appointed of any of its properties or business or
undertaking.
;ix< !e shall promptly inform the lead institution of any labour strikes, lock'outs, shutdown etc. or
other similar happenings likely to have an adverse effect on the borrower-s profits or business
and of any material changes in the rate of production or sales of the borrower with an
explanation of the reason therefore.
;x< !e shall submit its duly audited accounts within prescribed period ;generally six months< after
the close or its accounting year. +n case statutory audit ;if re"uired< is not likely to be completed
during this period, the borrower shall get, its accounts audited by an independent firm of
BSPATIL 112
4hartered )ccountants and furnish the same to lead institution.
;xi< !e shall maintain records showing expenditure incurred on the pro$ect, disbursement of the
loans, progress of the pro$ect and the operations and financial conditions of the borrower and
such records shall be open to examination.
;xii< !e shall not create any subsidiary or permit any company to become its subsidiary.
;xiii< !e shall not undertake or permit any merger, consolidation, reorganiation or amalgamation
scheme or compromise with its creditors or shareholders.
;xiv< !e shall not make any investments by way of deposits, loans, share capital etc., in any concern.
;xv< !e shall not carry on any general trading activity other than sale of its own product.
;xvi< !e shall not remove any person by whatever name called exercising substantial powers of
management of the affairs of the borrower at the time of execution of loan agreement without
the consent of lead institution.
;xvii< !e shall not undertake any new pro$ect, diversification, moderniation or substantial expansion
of the pro$ect.
;xviii< !e shall not issue any debentures, raise any loans, accept deposits from public, issue e"uity or
preference capital, change its capital structure or create any change on its assets or give any
guarantee without prior approval of lead institution.
;xix< !e shall not pay any commission to its promoters, directors, managers or other persons for
furnishing guarantees, counter guarantees or indemnities or for undertaking any other liability in
connection with any financial assistance obtained for or by the borrower or in connection with
any obligation undertaken for or by the borrower for the purpose of pro$ects.
;xx< !e shall not declare or pay divided to its shareholders during any financial year unless it has
paid all the dues to the lender.
;xxi< !e shall not repay any loan availed from any other party without the prior approval of the lead
institution. +f for any reason, the borrower is re"uired to repay any loan, it shall make
proportionate repayment to the lenders as well sub$ect to such conditions as may be stipulated
by lender.
Significance of o)enant( H The following is the significance of incorporating the above covenants in a
loan agreement.
;i< They provide security of loan and their repayment in time.
;ii< They bind the company to comply with the instructions of the lead institution in their operations.
;iii< They authorie the term lending institution to appoint the nominee directors on the board of
borrowing company. The nominee directors have to keep a watch on the following activities of
the borrowing companies and take appropriate measures in public interest.
a. The financial performance of borrowing company@
b. (ayment of dues to the institutions@
c. (ayment of government dues vi., custom duty and other statutory dues. +n case the
borrowing company feels that the demand is un$ustified, the nominee directors should
satisfy them selves regarding prima facie reasonableness of the company-s case.
BSPATIL 111
d. +nter'corporate investments and sale of shares.
e. )ll significant purchase and sale of shares@
f. 7xpenditure incurred by the company regarding awarding of contracts, purchasing and
selling or raw materials, finished goods, machinery etc.
;iv< They see that the borrowing company makes use of the funds only for the purpose for which
such funds have been sanctioned.
;v< They help the financial institutions in performing the development role consists with the national
priorities.
B#I3.E FINANE
The term, >Bridge %inance- refers to the loans taken by firms, generally from commercial banks,
pending disbursement of term loans from financial institutions, vi., +DB+, +%4+, +4+4+, etc. +t may be
noted that there is a always a time gap between the date of sanctioning of a loan its disbursement by
the financial institution to the concerned borrowing firm. +n order to prevent delay in starting their
pro$ect, the firms arrange from the commercial banks short'term loans which are later on repaid as and
when term loan disbursements are received from the financial institutions.
The bridge finance is secured against mortgage of fixed properties and H or hypothecation of movable
properties of the borrowing firm. The rate of interest on such a finance is usually higher than that on
term loans.
LOAN S=N3IATION
Boan syndication involves commitments for term loans from the financial institutions and banks for
financing a particular pro$ect. +n other words, in loan syndication, two or more financial institutions H banks
agree to finance a particular pro$ect. &ne of the institutions may become a lead institution and bring about
coordination in the financing arrangements of different financial institutionsH banks.
) loan syndication arrangement may be made in any of the following ways*
1. The borrower may directly make the loan application to a lead financial institution, which in turn gets
in touch with other financial institutions H banks interested in participating in the financial assistance
to the borrower. The advantage of such arrangement would be that the borrower would not have to
approach different financial institutions.
0. The borrower may approach a merchant bank to arrange for a loan syndication for him. The
merchant bank discusses the matter with the financial institution interested in workings as a lead
financial institution. The merchant bank submits a formal application to the financial institution for
the term loan. &n receiving such an application the financial institution examines the proposal
before accepting it for loan syndication.
The steps involved in a loan syndication arrangement can be put as follows*
1. (reparation of the pro$ect report,
0. (reparation of loan applicaton,
8. #election of the financial institution for loan syndication,
=. ,eceipt of sanction latter or letter or intent from the financial institution.
3. 4ompliance of the terms and conditions of the loan arrangement by the borrower,
BSPATIL 110
C. Documentation, and
D. Disbursement of loan.
BOO8 BUIL3IN.
Book'building is a novel and growing concept in +ndia. )ccording to this concept, the issuing company is
re"uired to tie up the issue amount by way of private placement. The issue price is not determined in
advance. +t is determined by offer of potential investors about price which they may be willing to pay for the
new issue. +n order to determine this price, the issuing company organies road shows and various
advertisement companies. in course of this process the issue manager or book'builder notes the amounts
offered by various investors such as institutional investors, mutual funds, underwriters, foreign institutional
investors, etc. The price of the instrument ;i.e. e"uity share, debenture or bond< is the weighted average
price at which the ma$ority of the investors are willing to buy the instrument.
This can be understood with the following example.
E>ample/ R Btd. issued bonds of ,s. 122 each amounting in all of ,s. 1,222 crores. +f appointed Ar. T as a
book ? runner H issue manager. !e got the following information at which different investor were willing to
purchase the bonds.
Iuoted (rice per bond Total )mount of Bonds
;in ,s. 4rores<
(1 ,s 13 122
(0 1G 322
(8 121 122
(= 122 022
(3 11 122
The issue price can not be calculated as follows*
(rice ;in ,s.< )mount of Bonds
;in ,s.<
Total
;in ,s.<
;p< ;w< ;in 4rores< ;pw< ;4rores<
13 122 1,322
1G 322 =1,222
121 122 1,122
122 022 02,222
11 122 1,122
w1222 crores pw 1D,322
pw
+ssued (rice based on .eighted )verage '''''''''''''''''
w
BSPATIL 118
1D,322
9 ''''''''''' 9 ,s 1D.32
1222
Book'building as a method of raising funds has been approved by #7B+ w.e.f. 5ov.1113. &f course, it has
been provided that this method can be used only when the issue exceeds ,s. 122 crores and one of the
lead managers to the issue has to be appointed as the book'runner to the issue.
Book ? building helps in evaluating the intrinsic worth of an instrument and the company-s credibility in the
eyes of the investor. The company also gets firm commitments on the basis of which it can decide whether
to go or not to go for a particular issue of securities.
P#OMOTE#@S ONT#IBUTION
+n order to ensure promoter-s interest in the pro$ect, financial institutional insist before financing a new
pro$ect or expansion of the plant that the promoter should also contribute minimum amount to be
contributed by the promoter is termed as >(romoter- 4ontribution-. The financial institutions had earlier laid
down certain norms for such promoter-s contribution. !owever, these norms have recently undergone a
change due to 6overnment-s policy for encouraging entrepreneurs to reduce their dependence on
financial institutions and to raise funds from the capital markets. )s a result, financial institutions not
stipulate a promoter-s contribution of around 82M of the pro$ect cost, although no specific guidelines have
been issued for the same.
The #ecurities 7xchange Board of +ndia ;#7B+< has laid down the following norms for promoter-s
contribution in case of pubic issues.
The #ecurities 7xchange Board +ndia ;#7B+< has laid down the following norms for promoter-s contribution
is case of public issues.
The #ecurities 7xchange Board of +ndia ;#7B+< has laid down the following norms for promoter-s
contribution in case of public issues.
#ie of capital issue ;including
premium<
+apital issue size &#s. in crores'
M of
promoter-s
322 1,222 0,322
&n first 122 crores of issue 32 32 32 32
5ext 022 crores =2 G2 G2 G2
5ext 822 crores 82 C2 12 12
Balance issue amounts 13 '' C2 0G3 ;ad$usted to
823<U
Total promoter-s 4ontribution 112 0G2 323 ;ad$uste to
303<U
)verage (ercentage 4ontribution 8GM 0GM 02.2Me
BSPATIL 11=
U5ote * The last slab in the case of issue of ,s. 0,322 crore has to be ad$usted so that the total contribution
by the promoters works out to 01M of the issue capital. +n other words, the slab shall be calculated at the
rate of 1C.23M so that the amount shall be ,s. 823 crores instead of ,s. 0G3.
NE- FINANIAL INSTITUTIONS AN3 INST#UMENTS
The +ndian 4apital Aarket especially in the eight has been undergoing tremendous changes to cater the
varied needs of capital of the various sectors of economy. +ts growth and development has further been
facilitated by the policy measures taken by the ,eserve Bank of +ndia and the 6overnment of +ndia with the
ob$ective of speeding up the tempo of institutionaliation of savings and investment.
The new policy measures have facilitated by established of new financial institutions and also introduction
of innovative financial instruments as discussed below*
1/ NE- FINANIAL INSTITUTIONS
The following are some of new financial institutions which have been recently setup for a fast growth of the
capital market*
1/ !enture apital In(titution(
oncept of !enture apital H Kenture capital is a form of e"uity financing designed specially for
funding high risk and high reward pro$ects. +t not only plays an important role in financing hi'
technology pro$ects, but also helps to turn research and development pro$ects into commercial
production. venture capital, besides financing the technology, is also involved in fostering the
growth and development of enterprises. +n the western countries much of this capital is put behind
establishing technology and expanding business or is used to help the evolution of new
management teams.
!enture Fun0( in In0ia H The venture fund or venture capital schemes is of recent origin in +ndia. The
following are some of the institutions which have established venture funds in +ndia.
;i< ,isk 4apital %oundation of +%4+* The first venture fund in the name of ,isk 4apital %oundation
was sponsored by the +ndustrial %inance 4orporation of +ndia ;+%4+< in Aarch, 11D3. +t was
reconstituted as ,isk capital and Technology %inance 4orporation Bimited ;,4T4< in January,
11GG. )t present ,4T4 operates three schemes, vi., ,isk 4apital #cheme. Technology
%inance and Development #cheme and Kenture 4apital Unit #cheme. Under the first two
schemes, the 4orporation provides supplementary assistance to new entrepreneurs particularly
technologies and professionals for promoting medium ? sie industrial pro$ects both in the form
of rupee loans and direct subscription to their share capital. while under he Kenture 4apital fund
of ,s. 82 crores. ;,s. 02 crores from +%4+ and ,s. 12 crores form the .orld Bank< has been set
up in July, 1111. The aim of the scheme is to provide venture capital for potentially highly
profitable venture involving innovative product technology H service aimed at futuristic or new
markets.
The cumulative sanctions and disbursements under the schemes of ,4T4 at the end of 81
st
Aarch, 1118
amounted to ,s.. D1.1 crores and =G.3 crores respectively. ) sieable portion of the sanctions and
disbursements were in respect of risk capital scheme.
;0< !enture Fun0 of I3BIH The +ndustrial Development Bank of +ndia ;+DB+< also started venture capital
BSPATIL 113
scheme in 11GC. The cumulative sanctions and disbursements under the scheme since its inception
to the end of Aarch, 1118 amounted to ,#. =C.G crores and ,s. 8G.8 crores respectively.
;8< !enture apital Fun0 of SI3BI H The #mall +ndustries Development Bank of +ndia ;#+DB+< has also
set up a venture capital fund with an initial corpus of ,s. 12 crores during the year 1110'18. The
funds is exclusively meant for providing financial assistance for innovative venture in small'scale
sector.
;=< !enture apital Fun0 of Tec1nolog9 3e)elopment an0 Infra(tructure orporation of In0ia
&T3II'H The 4orporation has been set up by +ndustrial 4redit +nvestment 4orporation of +ndia
;+4+4+< for providing technology information and financing commercial research and development
schemes. +t also manages the venture capital fund of ,s. 82 crores which +4+4+ has established
along with UT+ in 11GG.
The cumulative sanctions and disbursements by TD+4+ as at the end of Aarch, 1118 stood at ,s.
G1.0 crores and ,s. CC.1 crores respectively.
;3< Ot1er !enture apital Fun0( H Besides the public financial institutions ;+DB+, +%4+, +4+4+ and
#+DB+<, as discussed above, certain banks, vi., #tate Bank of +ndia, has set up the venture capital
fund through its subsidiary #B+ 4apital Aarkets Bimited. 4anara Bank has also set up a venture
capital fund through its subsidiary 4anBank %inancial #ervices Bimited. 6rindlays Bank has also
launched +ndia +nvestment %und. The funds raised from abroad 5,+s. +t is going to provide venture
finance to suitable pro$ects out of this fund.
+n the private sector, the 4redit 4apital 4orporation has set up the 4redit 4apital Kenture %und +ndia Btd.
The 4orporation intends to involve multinational bodies like )sian Development Bank and 4ommonwealth
fund in its financing. .ui0eline( for !enture apital Fun0 ompanie(/ The 6overnment of +ndia
announces on 5ovember 03, 11G1 certain guidelines regarding establishment and functioning of venture
capital funds companies. These guidelines are summaried below*
;1< E(ta4li(1ment H )ll +ndia (ublic #ector %inancial +nstitutions. #tate Bank of +ndia and other
scheduled banks including foreign banks operating in +ndia and the subsidiaries of the above would
be eligible to start Kenture 4apita KentureH4ompanies sub$ect to such approval as may be re"uired
from ,eserve Bank of +ndia in respect of banking companies. in all other cases approvals would be
given by the Development of 7conomic )ffairs, Ainistry of %inance or such authority as may be
nominated by the 6overnment.
;0< !enture apital A((i(tance H The assistance has to go mainly to enterprise where the risk
element is comparatively high due to technology involved being relatively new and Hor the
entrepreneur being relatively new and not affluent through otherwise "ualified. The total investment
in the enterprise should not exceed ,s. 12 crores.
;8< SiAe H The minimum sie of Kenture 4apital 4ompany H %und would be ,s. 12 crores. +f it desired to
raise funds from the public, the promoters- share shall not be less than =2M. The debt'e"uity ratio
may be maximum 1*1*3.
*/ Mutual Fun0(
BSPATIL 11C
) number of banking companies and some financial institutions have, by forming separate subsidiaries,
started mutual funds. #uch a mutual fund company invests the pooled funds of many shareholders
and thus give them the benefit of diversified investment portfolio. Autual funds can be classified into
two categories *
;1< Open en0 Mutual Fun0(H +n case of these funds, the fund itself is ready to buy back the shares
surrendered and sell new shares. Thus, there is not fixed number of outstanding shares. &rdinarily
the transaction of purchase of sale is made at the net assets value calculated every now and then.
The repurchase price is usually slightly lower than the selling price. The net assets value of the
mutual fund increases or decreases depending up on the mutual fund. Aost of the mutual funds
started by the commercial banks in over country fall in this category.
;0< lo(e en0 Mutual Fun0(H +n case of these funds, the mutual fund management sells a limited
number of shares. +t does not stand ready to redeem or repurchases these shares. (rimary
example of such a mutual fund is UT+ master share. The shares of such a mutual fund are
purchased and sold in the secondary markets.
#everal commercial banks in +ndia have recently entered inot the fields of mutual funds, vi., #B+ Autual
%und' management, 4anshare %und or 4anstock %und or 4anara Bank, #warnpushpa Autual %und of
+ndian Bank, Boi Autual %und of Bank of +ndia etc. Besided +T+, 6+4, Bife +nsurance 4orporation of +ndia
have also entered this area. #ome other banks are also likely to enter this market.
The mutual fund scheme offers the advantages of high return, easy li"uidity, safety and tax benefits to the
investment while it offers the bank an opportunity to collect funds from untapped areas.
&f course, the entry of commercial banks in the field of mutual fund has ended the monopoly if UT+ and B+4
and helped in providing stability to the stock market. !owever, their entry can be $ustified only when the
mutual fund schemes succeed in mobiliing additional savings and investing them as per national priorities.
4ommercial banks have the advantages of having a large number of branches in rural areas. it is,
therefore, hoped that their initiation of mutual fund schemes will benefit a large ma$ority of rural populations
and not only a small privileged minority living the urban areas.
+/ Factoring In(titution(
oncept H %actoring service has gained strong momentum in advanced countries of the .est. +nitially,
the factoring was considered to be a financial service under which the factor usually a bank undertook
collection of client-s debts, and finance the client on the basis of his accounts receivable.
!owever, the scope of factoring in modern times has considerably increased. +t is a continue service
arrangement under which a financial institution undertakes the task of recording, collecting, controlling
and protecting the book debts for is clients including the purchase of hi bill or receivable. Thus, as a
result of factoring services, the manufacturer, seller or dealer in goods can concentrate on
manufacturing, advertising and selling functions alone, the record'keeping functions of sales, book,
debts, bill receivable and their utiliation are completely vested with the factoring agency. The is result
in the following ma$or benefits to the client*
;i< ,eduction in the cost of maintenance and collection of book debts@
;ii< #aving in time, man'power etc., needed for collection@ and
;iii< Aonitoring of book debts and prevention of bad debts since the debentures would not like to be
BSPATIL 11D
looked down in the eyes of factoring credits institution.
Function( H The functions of a factoring credit institution can be grouped into the following categories*
;i< 4redit recording* +t involves maintenance of debtor-s ledger, collection schedules, discount
allowed schedule, ascertainment of balance due, etc.
;ii< 4redit administration* +t includes the work of collecting the book debts. The factoring institution
receives service charges by way of discount or rebate deducted from the bill or bills.
;iii< 4redit protection* The factoring institution eliminates the risk of loss of the client by taking over
the responsibility of book debts due to the client.
;iv< 4redit financing* The factoring institution advances appropriation of the value of book debts of
the clients immediately, and the balance on maturity of book debts. This improves the client-s
li"uidity position in the sense that book debts have been substituted by cash.
;v< %inance and business information. ) factoring institution also advice the client on the prevailing
business trend, financial and fiscal policy, impending development in commercial and industrial
sector, potentials for foreign collaboration, transfer of technology, export and import potential,
identification and selection of potential trade debtors, etc.
Thus, factoring service is more than simply a method of business finance. The ,eserve Bank of +ndia has
initiated several measures to develop factoring service. +t appointed a working group popularly known as
Koghul committee to explore the possibility of encouraging the factoring service for collection of dues and
book debts on behalf of the suppliers. The committee recommended in its report in 11GD for introduction of
factoring service in the country. +t advised banks as well as private non'banking financial institution to
develop factoring service. )s a follow up measure, the ,B+ on January 11, 111G constituted a #tudy 6roup
under chairman ship of #hri :alyan #undaram to examine the feasibility and mechanism of starting
factoring services.
)s a result of the recommendations of the above group, the 6overnment of +ndia notified factoring is an
eligible activity for the banking.
)t present there are two factoring companies operating in +ndia, vi., #B+ %actors Q 4ommercial #ervices
(vt. Btd., a subsidiary of #tate Bank of +ndia and 4anbank %actors Btd., a subsidiary of 4anara Bank. .hile
the #B+ %actors with its corporate office at Bombay has $urisdiction over Aaharashtra, 6u$arat, Aadhya
(radesh and 6oa #tates, Diu and Daman Union Teritory. 4anbank factors with is corporate office at
Bangalore has $urisdiction over the southern #tates.
.e are explaining below the details of the factoring services undertaken by #B+.
Factoring Ser)ice( 49 State Ban, of In0ia
The first factoring service in +ndia was launched with from #eptember 1, 1111 by the #tate Bank of +ndia, in
collaboration with #mall #cale +ndustries Development Bank of +ndia ;#+DB+< and some other commercial
banks. These institutions have together launched a new company called #B+ %actors and 4ommercial
#ervices Btd. ) brief description of the institution and its functioning is given below*
1. #hare 4apital *The company has a subscribed share capital of ,s. 03 crores. The share capital is
held by the #tate Bank of +ndia 3=M, #+DB+ 02M #tate Bank of #aurashtra 12M@ Union Bank of
BSPATIL 11G
+ndia 12M and #tate Bank of +ndore CM.
0. .orking (rocedure * The working procedure involved in the factoring services can be summaried
as follows*
a. The supplier invoices his customers in the usual way only adding the notification that the
debt due on the invoice is assigned to and must be paid to the #B+ factors.
b. The supplier offers assigned invoices to #B+ factors with a schedule of offer accompanied
by the receipted delivery challans.
c. The #B+ factor provide pre'payment to the supplier up to G2M of the invoice value. it also
performs the accounting function of sales ledger maintenance and collection function of
realiing invoices purchased.
d. The #B+ factors sends on official notification and personalied statement of accounts of
different customers of the supplier.
e. &n receipt of payment from the customer, the #B+ factors pay the remaining 02M of the
invoices value to the supplier.
f. +n order to keep the supplier informed of the factors invoices, the #B+ factors send monthly
statement of accounts to the supplier.
The greatest benefit of the factoring services to the supplier is he can convert his invoice into instant
cash upto G2M of his value without having to wait for the usual 82 or more credit days.
8. #ervice %ee. * ) service fee is levied for the work involved in maintaining sales ledger and collection
of the debts on the invoices. +t will be calculated as a percentage of the gross value of the invoices
factored, based on ;a< the gross sales volume, ;b< the number of customer, ;c< the number of
invoices and credit notes, and ;d< work involved in collection. The service fee will range between
two and five percent of the gross value of the invoices.
5/ re0it #ating In(titution(
oncept H The concept of credit rating originated in the U#). The primary ob$ective ofcredit rating is to
provide guidance to investorsHcreditors in determining the credit risk associated with a debt instrumentH
credit obligation by and independent professional and impartial institution. )t present there are a few credit
rating institution in the country. These include ;i< 4redit ,ating information and #ervices +ndia Bimited
;4,+#+B<, ;ii< +nvestment +nformation and 4redit ,ating )gency of +ndia Bimited ;+4,)<, ;iii< &nida
+nformation and 4redit ,ating )gency of +ndia Bimited ;&5+4,)< and, ;iv< 4redit )nalysis Q ,esearch
Bimited ;4),7<. .e are giving below briefly the details about each of these institutions.
;a< ONI#A H +t was set up in 1118 by the &nida 6roup for assessing the credit worthness of the
individuals seeking finance for purchase of consumer durables or trade credits.
;b< re0it Anal9(i( 2 #e(earc1 Lt0/ H 4),7 was also set up in 1118 by +DB+ in collaboration
withsome banks and financial services companies. as on Aarch 81, 111C the number of cumulative
credit rating assignments completed by 4),7 stood at =G= of which ==3 related to debt
instruments for a total debt of ,s. 08,C8G.
;c< re0it #ating Information 2 Ser)ice( of In0ia &#ISIL' H The 4redit ,ating +nformation Q
#ervices of +ndia Bimited ;4,+#+B< was set up by the financial institution on January 11, 111G, to
BSPATIL 111
facilitate the processing of proposals and giving of approvals by the #7B+ for companies going to
the public for raising funds through issue of securities.
%hare +apital * 4,+#+B has a capital base of ,s. = crores.
Functions* 4,+#+B has proved to be a boon to both companies and investors through its following
functions*
;i< +t provides an independent and unbiased report about the creditworthiness of company. Thus, it
enables it to mobilie directly savings from individuals at reasonable cost.
;ii< +t provides reliable financial information and increased disclosure to investors. Thus, it enables
them to buy securities with confidence.
6oring* )t present 4,+#+B is restricting its rating only to debt instruments, vi., fixed deposits,
debentures, and debenture portion of e"uity linked debentures. There is no compulsion for any
company to obtain or publicie the rating obtained from 4,+#+B. !owever, once credit rating is made
compulsory by the 6overnment. 4,+#+B is planning to undertake credit rating of all types of securities.
+#0%0) has to evaluate and monitor the performance of a company through use of "ualitative as well
as "uantitative criteria for evaluation. The "ualitative criteria include the company-s competitive
position, its strengths and weakness, its management and business strategies, etc. while the
"uantitative criteria include the financial statements the accounting ratios, the cash flow and funds flow
statements of the company concerned.
Progre(( of #ISIL; #ince its inception till Aarch 81, 111C, 4,+#+B has so far completed rating of
1,D8C issues consisting of various types of debt ,s. 1,1=,GD8 crores. #ome of the companies which
have used 4,+#+B rating are +ndian (etro 4hemicals Bimited ;+(4B<, #undaram %iannce Bimited ;#%B<,
Aahindra 7ngine #teel 4ompany Bimited, Aukand &il Q #teel works Bimited, :irloskar Bros. Bimited,
Aunicipal Bonds of )hmedabad Aunicipal 4orporation etc. During the year 1110'1= 4,+#+B launched
the ,)T+56D+67#T, which is a compilation in five volumes of 4,+#+B ,ating ,eports organied by
industries categories. +n 1113 ? 1C it introduced 4,+#+B ? 322 7"uity +ndex.
4redit rating analysis is relatively, new development in +ndia. +t is expected that establishment of 4,+#+B,
will provide a strong impetus to the systematic risk evaluation of specified corporate instruments as well as
the companies issuing them.
;a< I#A Lt0/ I#A formally known as the investment +nformation Q 4redit ,ating )gency of +ndia
;+4,)< was promoted by the +ndustrial %inance 4orporation of +ndia ;+%4+<. +t was incorporated on
Jan. 1C, 1111 as public limited company and started functioning with effect from #eptember 1,
1111.
The +4,) also performs credit rating functions and finalies its rating norms and standards in
consultation with 4redit ,ating +nformation Q #ervices of +ndia Btd. ;4,+#+B< +4, ) has an authoried
4apital of ,s. 12 crores. +ndustrial %inance 4orporation of +ndia ;+%4+<, Unit Trust of +ndia, Bife
+nsurance 4orporation of +ndia, 6eneral +nsurance 4orporation of +ndia, !ousing Development %inance
4orporation of +ndia, +nfrastructure Beasing and %inancial #ervices, #tate Bank of +ndia, and 1D
commercial banks are its shareholders.
(rogress of +4,), #ince its inception till end of Aarch, 111C +4,) has rated DDG debt instruments
involving an amount of ,s. 18,8G2.
The 6overnment has already announced compulsory rating for all debentures end bonds expect the
BSPATIL 102
following *
1. +ssue of non'convertible debentures upto ,s. 3 crores on private placement basis including with
mutual funds.
0. )ll issues of fully convertible into e"uity shares within 1G months from the date of issue at per
determined price.
8. (ublic sector bonds and private placement of debentures with financial institutions ? banks.
+n the above cases, obtaining credit rating by the concerned company H institution is optimal. !owever,
where rating is re"uired it is also obligatory for the concerned company to announce the result of rating.
BSPATIL 101
UNIT !III
-O#8IN. APITAL MANA.EMENT
oncept of -or,ing apital
Bike the broader concept of capital, there is no universally accepted definition of working capital. )s 6ilbert
!arold puts this problem, EUnfortunately there is so much disagreement among financiers, accountants,
businessmen and economists as to the exact meaning of the term >working capital-. it is "uite true. Karious
financial theorists have used this term in a number of ways. #ome explain it in a narrow sense while some
others in a very wide sense. +n narrow sense, some authorities define the term as the difference between
current assets and current liabilities. &ther writers think of working capital as being e"ual to the total of the
current assets. &n the other hand, some writers like 6erstenberg are not ready to call it as >working
capital-. They prefer to all it as >4irculating 4apital- so we shall have to go through the various concepts of
working capital before reaching at any conclusion.
3efinition( of :or,ing apital
+n the broad sense, the term >working capital- is used to denote the >total current assets-. The following are
some definitions of this group.
;1< E.orking 4apital means current assets.F
' Mea0 Ba,er Malott/
;0< EThe sum of the current assets is the working capital of a business.F
' J/S/ Mill/
;8< E)ny ac"uisition of funds which increases the current assets increase working capital also, for they
are one and the sameF.
' Bonne)ille
;=< >.orking capital refers to a firm-s investment in short'term assets ? cash, short'term securities,
accounts receivable and inventories.F
' -e(ton 2 Brig1am
+n the narrow sense, the working capital is regarded as the excess of current assets over current
liabilities. This is the definition used by most financial experts and authors emphasiing the accounting
phase of finance. They include the name of 7.7. Bincoln, 7.). #aliers, and 4... 6erstenberg etc.
6erstenberg defines it as follows * 0t has ordinarily been defined as the e2cess of current assets over
current liabilities.
Thus we see there is no difference in authorities over the true concept of working capital. the true
difference is on it "uantity. The total current assets minus current liabilities approach refers to net
working capital. the total current assets approach has a broader application and it is more inviting to the
financial management. +t takes into consideration all the current resources of the enterprise, from
whatever source derived and their application to the current and future activities of the enterprise. +n the
words of .alker and Bauglin. E) good current ratio may mean a good umbrella for creditors against
>rainy day-, but to the management it reflects and financial planning or presence of ideal assets or over
BSPATIL 100
capitalisation.F )ctually speaking, a successful financial executive is interested not in maintaining a
good current ratio but in maintaining an ad$ustable account assets so that the business may operate
smoothly. That-s if the term >working capital is used without future "ualification, it generally refers to the
gross- working capital.
8in0( of -or,ing apital
.orking capital can be classified on the basis of its composition. Thus, we can have gross working
capital comprising current assets and net working capital representing current assets minus current
liabilities. %rom the viewpoint of the finance manager this basis of classification is helpful since it
categories the various areas of financial responsibility. %or instance, funds invested in cash, inventories
and receivable re"uire careful planning and control if the firm is to maximie its return on investment.
.hile the above classification is very significant to the financial management, it is not completely
ade"uate as it does not mention about time. Time is an important variable which influences pattern of
financing working capital re"uirements. Using times as a basis, working capital may be categoried as
permanent an0 )aria4le :or,ing capital/
(ermanent working capital represents current assets re"uired on a continuous basis over the entire
year. ) manufacturing enterprise has to carry irreducible minimum amount of inventories necessary to
ensure continued production and sales. Bikewise, some amount of funds lie tied in receivables where
the firm sells goods on credit terms. #ome amount of cash has also to be held by the firm so as a to
exploit business fluctuations. Thus, minimum amount of current assets which firm has to hold for all the
time to come to carry on operations at any time is termed as permanent or regular working capital. +t
represents >hare core- of the working capital. permanent working capital changes constantly its form
from one asset to another whereas fixed assets retain their form over a long period of time. %urther,
fund of value representing permanent working capital never leaves the business process and therefore,
the suppliers should not expect its return until the business ceases to exit. %inally, permanent working
capital will tend to expand so long as the firm experiences growth in its operation.
&ver and above permanent working capital, the firm may need additional current assets temporarily to
satisfy seasonalHcyclical demands. Thus, for example, added inventory must be held to support the
peak selling periods. ,eceivable increase following periods of high sale. 7xtra cash may be need to
pay for additional supplies following expansion in business activity. #imilarly, in periods of dull business
conditions when most of the produce remains held in stock due to precipitate fall in demand, the
company would re"uire additional cash to tide over the crises. 7xcess amount of working capital may
be carried to face cut'throat competition or any other contingencies like strikes and lockouts.
This additional amount of working capital represents variable or temporary working capital, sie of
which depends upon changes in levels of production and sales resulting from changes in market
conditions. %unds re"uirements for this purpose are of short duration.
Importance of -or,ing apital
.orking 4apital is $ust like the heart of business. +f it becomes weak, the business can hardly prosper
and survive. +t is an index of the solvency of a concern. +ts proper circulation provides to the business
the right account of cash to maintain regular flow of its operations. The following are the some worth
mentioning advantages of maintaining an ample working capital fund in the business.'
;1< a(1 3i(count +f proper cash balance is maintained, the business can avail of the cash
BSPATIL 108
discounts facilities offered to it by the suppliers.
;0< Li<ui0it9 an0 Sol)enc9 The proper administration of working 4apital enhances the li"uidity in
funds and solvency and credit ? worthiness of the concern.
;8< Meeting un(een ontingencie( +t (rovides %unds for unseen emergencies so that a business
can successfully said through the periods of crisis.
;=< "ig1 Morale The provision of ade"uate working capital improves the morale of the executive and
their efficiency reaches it highest climax.
;3< .oo0 Ban, #elation( 6ood relations with banks can also be maintained. The enterprise by
maintaining an ade"uate amount of working capital is able to maintain a sound bank credit,
trade credit and can escape insolvency.
;C< Fi>e0 A((et( Efficienc9 Incurre0 %ixed assets of the firm also can not work without proper
amount of working capital. without it, fixed assets are like guns which can not shoot as there are
no cartridges.
;D< #e(earc1 an0 Inno)ation Programme( 5o research programme, innovation and technical
developments are possible to undertake without sufficient among of working capital.
;G< E>pan(ion Facilitate0 The expansion programme of a firm is highly successful, if it is financed
through own working capital.
;1< Profita4ilit9 Increa(e0 The profitability of a concern also depends, in no small measure, on the
right proportion of fixed assets and current assets. 7very activity of the business directly or
indirectly affects the current position of the enterprise hence its needs should be properly
estimated and calculated.
Thus the need for maintain an ade"uate working capital can hardly be "uestioned. Just as circulation of
blood is very necessary in the human body to maintain life, smooth flow of funds is very necessary to
maintain the health of the enterprise. The importance of working capital can be very well explained in the
words of !usband and Dockery * EThe price ob$ect of management is to make a profit. .hether or not this
accomplished in most business depends largely on the manner in which the working capital is
administered.
3eterminant( of -or,ing apital &T1e amount of :or,ing capital'
There are numerous factors which affect the working capital of a concern, the appraisal of which assets
management in formulating its policies and estimating its prospective re"uirements. The important factors
are as follows*
;1< Nature of Bu(ine(( The effect of the general nature of the business on the working capital
re"uirements can not be exaggerated. ,ail roads, and other, public utility services have large
fixed investment, so they have the lower re"uirements for current assets. +ndustrial and
manufacturing enterprises on the other hand, generally re"uired a large amount of working
capital. ) rapid turnover of capital ;sales divided by total assets< will inevitably meant a larger
proportion of current assets.
;0< Pro0uction Policie( The nature of production policy also exercises its impact on capital
needs. #trong seasonal movement have special workings capital problems and re"uirements. )
high level production plan also involves higher investment in working capital.
BSPATIL 10=
;8< T1e proportion of t1e co(t of #a: Material( to Total o(t( +n those industries where cost
of materials is a large proportion of the total cost of the goods produced or where costly raw
material is used, re"uirements of working capital will be rather large. But if the importance of
raw materials is small, the re"uirements of working capital will naturally be small.
;=< Lengt1 of perio0 of manufacture The time which elapses between the commencement and
end of the manufacturing process has an important being upon the re"uirements of working
capital. if it takes long to manufacture the finished pro$ect, naturally a large sum of money will
have to be kept invested in the form of working capital.
;3< #api0it9 of Turno)er Turnover represents the speed with which the working capital is
recovered by the sale of goods. +n certain business, sales are made "uickly so that stocks are
soon exhausted and new purchases have to be made. +n this manner, a small sum of money
invested in stocks will result in sales of a much large amount. +t will reduce the re"uirements of
more working capital.
;C< Term( of Purc1a(e( +f continuous credit is allowed by supplier, payment can be postponed
for some time and can be made out of the sale proceeds of the goods produced. +n such a case
the re"uirements of working capital will be reduced. The period of credit received and allowed
also determines the working capital re"uirements of the enterprise.
;D< .ro:t1 :it1 E>pan(ion of Bu(ine(( )s a company gross, it is logical to except the larger
amount of working capital will be re"uired. 6rowing concerns re"uire more working capital than
those that are static. The re"uirement of working capital also varies with economic
circumstances and corporate practices.
;G< Bu(ine(( 9cle( ,e"uirements of working capital also very with the business cycles. .hen
the price level is up due to boom conditions, he inflationary conditions create demand for more
working capital. During depression also a heavy amount of working capital is needed due to the
inventories being locked unsold and book debts uncollected.
;1< #e<uirement( of a(1 The working capital re"uirements of a company is also influenced by
the amount of cash re"uired by it for various purposes. The greater the re"uirements of cash,
the higher will be the working capital costs of the company.
;12< 3i)i0en0 Polic9 of t1e oncern +f conservative divided policy is followed by the
management the needs of working capital can be met with the retained earnings. &ften
variations in need, of working capital bring about an ad$ustment of dividend policy. The
relationship between divided policy and working capital is well established and mostly
companies declare divided after careful study of cash re"uirements.
;11< Ot1er Factor( +n addition to the above considerations there are a number of other factors
affecting the re"uirements of working capital, for example, lack of co'ordination in production
and distribution policies, the fiscal and tariff policies of the government etc.
) prudent financial manager is always manger is always interested in obtaining the correct amount of the
working capital at the right time, at a reasonable cost at the best possible favourable terms. To adopt the
right sources it is very necessary for him to have a through understanding of the firm-s short'term funds
needs, market for short'term funds, re"uired level of li"uidity in funds and risk assumption. ) firm
interested to obtain short'term funds has a choice of securing finance from alternative sources ? internal
as well as external. +n making any final choice as regards to sources of working capital the relative cost of
financing, dependability upon the source and flexibility in financial planning must be given due weightgae.
BSPATIL 103
Source( of -or,ing apital H
The following chart gives a snapshot view of various sources of working capital available for a firm*
Financing of Long7tem :or,ing apital
The long'term working capital re"uirements include the initial working capital and the regular working
capital. along with it, the minimum level of investment in various current assets also determines the
re"uirement of long'term working capital. This capital can be conveniently financed by the following
sources ?
;1< S1are apital ) part of long'term working capital can be financed with the share capital.
;0< Sale of 3e4enture( Debentures are also an important source of long'tern working capital
because they are fixed cost sources. ,ights Debentures have also been very popular in +ndia since
11DG.
;8< Ploug1ing 4ac, of profit( ) part of the earned profits may be ploughed back by the firm in
meeting their working capital re"uirements. +t is regular and cheapest sources of working capital as
it does not involve any explicit cost of capital.
;=< Sale of Fi>e0 A((et( )ny idle fixed asset can be sold out and sale proceeds can be utilied for
financing the working capital re"uirements.
;3< Term Loan( 7 The loans raised for a period varying from 8 to 3'D years are also important
sources for working capital. this type of finance is ordinarily repayable in installments. #uch loan
usually increases the working capital of the enterprises.
BSPATIL 10C
.orking 4apital #ources
Bong ? term #ources #hort ? term sources
1. #ale of shares
0. #ale of debentures
+nternal
8. (loughing back of
profits
=. #ale of idle fixed
3. Bong'term loans
1. Depreciation funds
0. (rovision for taxation
8. )ccrued expenses
1. Trade 4redit
0. 4redit papers
8. Bank credit
=. (ublic deposits
3. 4ustomer-s credit
C. 6ovt. )ssistance
D. Boans from Directors etc.
G. #ecurity of 7mployees
1. %actoring
Financing of (1ort7term -or,ing apital
This category of funds covers the need of working capital for financing day'to'day business re"uirements.
5ormally, the duration of such re"uirements does not exceed beyond a year. The sources of short'term
working capital may be internal as well as external.
&a' Internal Source(
;1< 3epreciation Fun0( The depreciation funds constitute important source for working capital.
some authors of business finance do not accept them as a source of funds but it is not reasonable.
;0< Pro)i(ion for Ta>ation The provisions for taxation can also be used by the companies as a
source of working capital during the intermitant periods.
;8< Accrue0 E>pen(e( The firm can postpone the payment of expanses for short periods. !ence
these accrued expenses also constitute an important source of working capital.
&4' E>ternal Source(
;1< Tra0e re0it &ne of the most important forms of short term finance is the trade credit extended
by one business enterprise to another on the purchase and sale of goods and e"uipment. The use
of trade credit has increased in recent years due mainly perhaps to the credit s"ueee. The trade
credit may also assume three forms *purchase on open account, purchasing on furnishing a
pronote for specified period and purchase on trade acceptance ;i.e. bills payable<
;0< Ban, re0it 4ommercial banks are also principal source of working capital. they provided
working capital in a number of ways such as overdrafts, cash credits, line of credit, short term loans
etc. 4ompared with other methods of borrowing this is the most flexible source because when the
debt is no longer re"uired it can be "uickly and early reduced. +t is also comparatively cheap.
;8< re0it Paper( +n the category of credit papers, bills of exchange and promissory notes of shorter
duration varying between a month and six months are used. These papers are discounted with a
bank and capital can be arranged. )ccommodation bills is an important method of such finance.
;=< Pu4lic 3epo(it (ublic deposits are also an important source of shot'term and medium ? term
finance. Due to shortages of bank credit in recent past, the importance of public deposits has
increased. They have been very popular among +ndian companies during last three years.
;3< u(tomer@( re0it )dvances may also be obtained on contracts entered into by the enterprise.
The customers are often asked to make some advance payment in cash in lieu of a contract to
purchase. #uch advance can be utilied in purchasing raw material paying wages and so on.
;C< .o)ernmental A((i(tance #ometimes, central and state governments also provide short'term
finance on easy terms.
;D< Loan( from 3irector( etc/ )n enterprise can also obtain loans from it officers, directors,
managing directors etc. These loans are often obtained at almost negligible rates of interest. #ome
times, no interest is charges on them. Boans an also to obtained from other fellow companies
working within the same group.
;G< Securit9 of Emplo9ee 7 +f employee-s are re"uired to make deposits with their employer
companies, such companies can utilie those amounts in meeting their working capital needs.
;1< Factoring %actoring involves raising funds on the security of the company-s debts, so that cash is
received earlier than it the company waited of the debtors to pay. Thus the factors help in improving
BSPATIL 10D
the company-s li"uidity position. But this finance is not cheap in comparison to bank credit etc.
The forecast of working capital re"uirements of a concern is not an easy $ob. The concept of working
capital is closely related to that current assets. #o, some experts of finance suggest that in estimations the
working capital re"uirements, the total current assets re"uirement should be forecasted. But, however, is
contention is not $ustified on logic as the short term needs of the funds are e"ually vitally affected by the
nature and composition of fixed assets. !ence, the problem of working capital forecast should be dealt
within the overall financial re"uirements of the concern.
Foreca(ting Tec1ni<ue( of -or,ing apital
+f the working capital is to be estimated for the ensuring year, then the current re"uirements of the assets
and cash flow for that period are to be estimated. The study of cash flow will reveal how much cash is
available to meet the current assets re"uirements. The basic ob$ect of forecasting working capital needs is
either to measure the cash position of the enterprise or to exercise control over the li"uidity position of the
concern. But, the circular flow of working capital does not occur automatically and it is the essential
responsibility of management to guide it in proper proportions through the production machine.
There are three popular methods available for forecasting working capital re"uirements*
;b< a(1 Foreca(ting Met1o0 +n this method the position of cash at the end of the period is shown
after considering the receipts and payments to be made during that period. +ts form assuring more
or less a summary of cashbook. This shows the deficiency or surplus of cash at the definite point of
time.
;c< T1e Balance S1eet Met1o0 +n the balance sheet method of forecasting, a forecast it made of the
various assets and liabilities of the business. )fterwards, the difference between the two is taken
which will indicate either cash surplus or cash deficiency.
;d< Profit an0 Lo(( A0?u(tment Met1o0 Under this method the forecasted profits are ad$usted after
adding the cash inflow and deducting the cash outflows. The basic idea under method is to ad$ust
the estimated profits on cash basis.
) forecast of working capital re"uirements can also be called a working capital budget. The main ob$ect of
preparing a working capital budget is to source an effective utiliation of the investment in current assets. +t
shows the behaviour of working capital with the volume of output or estimated sales.
E(timating -or,ing apital #e<uirement(
+n order to determine the amount of working capital needed by a firm, a number of factors vi. (roduction
policies, nature of business, length of manufacturing process, credit policy, rapidity of turn'over, seasonal
fluctuation, etc. are to be considered by the %inancial Aanager. Besides this a %inance Aanager can apply
any of the following techni"ues for assessing the working capital re"uirement of a firm.
Tec1ni<ue( for a((e((ment of -or,ing apital #e<uirement(/ %ollowing is a brief explanation for the
various techni"ues for assessment of a firm-s working 4apital re"uirements.
1. "stimation of +omponents of 6oring .ethod * #ince .orking capital is the excess of current
assets over current liabilities, an assessment of the working capital re"uirements can be made by
estimating the amounts of different constituents of working capital e.g., inventories, accounts
receivable, cash, accounts payable etc.
BSPATIL 10G
0. !ercent of %ales .ethod* This is a traditional and simple method of estimating working capital
re"uirements. )ccording to this method, on the basis of pas experience between sales and working
capital re"uirements, a ratio can be determined for estimating the working capital re"uirements in
future. %or example, if the past experience show that working capital has been 82M of sales and its
is estimated that the sales for the next year would amount to ,s. &ne lack, the amount of working
capital re"uirement can be assessed as ,s. 82,22
The basic criticism of this method that it presumes a linear relationship between sales and working
capital. This is not true in all cases san method is nto universally accepted.
8. -perating +ycle 1pproach * )ccording to this approach, the re"uirements of working capital
depends upon the operating cycle of the business. The operating cycle begins with the ac"uisition
of raw materials and ends with the collection of receivables. +t may be broadly classified into the
following four stages vi.
;i< ,aw materials and stores stage@
;ii< .ork'in progress stage@
;iii< %inished goods inventory stage@ and
;iv< ,eceivable collection stage@
The duration of the operating cycle for the purpose of estimating working capital re"uirements is e"uivalent
to the sums of the duration of each of these stages less the credit period allowed by the suppliers of the
firms.
#ymbolically, the duration of the working capital cycle can be put as follows*
& 9 , L . L % L D ? 4
.here,
& 9 Duration of opening cycle
, 9 ,aw materials and stores storage period@
. 9 .ork in process period@
% 9 %inished stock storage period@
D 9 Debtor-s collection period@
4 9 4reditor-s payment period.
7ach of the component of the operating cycle can be calculated as follows*
)verage stock of raw materials and stores
, 9 '''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''
)verage ,aw Aaterials and stores consumption per day
)verage work in process inventory
. 9 ''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''
)verage cost of production per day
)verage finished stock inventory
% 9 '''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''
BSPATIL 101
)verage cost of goods sold per day
)verage book debts
D 9 ''''''''''''''''''''''''''''''''''''''''''''''''''''
)verage credit sales per day
)verage trade creditors
4 9 ''''''''''''''''''''''''''''''''''''''''''''''''''''
)verage credit purchases per day
)fter computing the period of one operating cycle, total number of operating cycles that can be completed
during a year can be computed by dividing 8C3 days with the number of operating days in a cycle. The total
operating expenditure in the year when divided by the number of operating cycles in a year will give the
average amount of the working capital re"uirements.
Approac1e( for 3etermining t1e Finance Mi>
There are three approaches for determining the working capital financing mix.
;i< T1e 1e0ging approac1 )ccording to this approach, the maturity of sources of funds should
match the nature of assets to be financed. The approach is therefore also termed as EAatching
)pproachF. +t divides the re"uirements of total working capital funds into two categories.
a. Permanent -or,ing apital; i/e. funds re"uired for purchase of core current assets. #uch
funds do not vary over time.
b. Temporar9 or Sea(onal -or,ing apital; i/e. funds which fluctuate over time.
The permanent working capital re"uirements should be financed by long'term funds while the seasonal
working capital re"uirements should be financed out of short'term funds.
;ii< T1e on(er)ati)e Approac1 )ccording to this approach all re"uirements of funds should be
meet from long'term sources. The short'term sources should be used only for emergency
re"uirements.
The conservative approach is less risky, but mote costly as compared to the hedging approach.
+n other words conservative approach is Elow profit ? low riskF ;or high cost, high net working
capital< while hedging approach results in high profit'high risk ;for low cost, low net working
capital<.
;iii< Trade'off between hedging and conservative approached. The hedging and conservative
approach are both on two extremes. 5either of them can therefore help in efficient working
capital measurement. ) trade'off between these two can give satisfactory results. The level of
such trade'off will differ from case to case depending upon perception of the risky by the
persons involved in financial decision' making. !owever, one way of determining the level of
trade'off is by finding the average working capital so obtained may be financed by long'term
funds and the balance by short'term funds. %or example, if during the "uarter ending 81
st
Aarch, the minimum working capital re"uired is estimated at ,s. 12,222 while the maximum at
,s. 13,222, the average level comes to ,s. 10,322 Vi.e. ;12,222 L 13,222< 0W. The firm should
BSPATIL 182
therefore finance ,s. 10,222 from long'term sources while any extra capital re"uired any time
during the period, from short'term sources while any extra capital re"uired any time during the
period, from short'term sources ;i.e., current liabilities<
BSPATIL 181