Personal Website of R.Kannan
Learning Circle - Financial Services &
Financial Management - Frequently
Asked Questions

Home Table of Contents Feedback

Financial Analysis & Financial Tools - FAQs


- - - : ( o0o ) : - - -


  1. State and explain the various methods of raising long term finance.

    There are a number of sources from which Finance Managers of Companies can raise long term finance. The most important of these are :

    Share Capital

    1. Equity Share Capital
      Equity Capital represents ownership capital, as equity shareholders collectively own the company. They enjoy the rewards as well as bear the risks of ownership. From the Company's point of view, raising equity capital offers a number advantages

      1. Since there is no liability for repayments, it is a source of permanent capital

      2. There is no legal obligation to pay dividends. Therefore, dividend payment can be conveniently skipped till the project starts generating adequate surplus.

      3. Equity capital constitutes the basis for raising debt. In general the larger the equity base, the higher is the ability to raise debt capital

      However since dividends are paid out of post-tax profits, there is no tax shield available to the firm on account of this outflow.

      Companies while going in for public issue of equity shares may decide to offer a portion of the total issue to its existing share holders and when such offer is made to the exciting shareholder, it is termed as rights issue. The number of shares allotted to the existing shareholders is related to the number of shares already held by him.

    2. Preference Share Capital
      The holders of preference share capital have preference over equity shareholders to post-tax earnings in the form of dividends and assets in the event of liquidation. While the preference shareholders are entitled to dividend at a fixed rate, which cannot exceed 14%, the yearly payment of preference dividend is not obligatory. However, if in any year the post tax profits are insufficient or if there are no profits to pay preference dividends, such dividend is paid in the year in which the company makes profit, on cumulative basis.

      An additional advantage of preference share capital over equity share capital is that it does not result in dilution of control. Preference shareholders are not entitled to vote unless preference dividend is in arrears for a specified period of time. Investors consider this as the least preferred avenue of investment, since the dividend is limited to a maximum of 14% and there is no legal obligation for payment of even this amount

    Debenture Capital

    Debentures are instruments or raising long-term debt capital. Debenture holders are creditors of the company. The obligation of the company towards its debenture holders is similar to that of a borrower who promises to pay interest and capital at specified times. Interest payment on debenture is a statutory obligation, unlike dividend payments on equity shares. Interest paid on debentures is a tax-deductible expense. Debentures have to be compulsorily retired in accordance with the terms of the issue, whereas equity share capital need not be redeemed. Debenture holders are not entitled to vote. Debentures are usually secured by a charge on the immovable properties of the company. The interests of the debenture holders is usually represented by a trustee, which is usually an insurance company, a bank, or a firm of attorneys and this trustee is responsible for ensuring that the borrowing company fulfils the contractual obligations embodied in the contract. Debentures can be classified based on conversion, security and redemption. On the basis of convertibility, they can be classified into:

    1. Non Convertible Debentures (NCDs)
      These debentures cannot be converted into equity shares and will be redeemed at the end of the maturity period

    2. Fully Convertible Debentures (FCDs)
      These debentures will be converted into equity shares after a specified period of time at one stroke or in installments. These debentures may or may not carry interest till the date of conversion. In the case of a fully established company with an established reputation and good, stable market price, FCDs are very attractive to the investors as their bonds are getting automatically converted to shares which may at the time of conversion be quoted much higher in the market compared to what the debenture holders paid at the time of FCD issue

    3. Partly convertible Debentures (PCDs)
      These are debentures, a portion of which will be converted into equity share capital after a specified period, whereas the non-convertible (NCD) portion of the PCD will be redeemed as per the terms of the issue after the maturity period.

    Debenture capital offers the following advantages to the issuing company:

    1. The cost of debt capital represented by debentures is much lower than the cost of preference or equity capital.

    2. Debenture financing does not result in dilution of control since debenture holders are not entitled to vote

    3. The call provision found in many debenture issues provides flexibility in changing the capital structure

    4. In a period of rising prices, debenture issue is advantageous. The burden of servicing debentures, which entails a fixed monetary commitment for repayment of interest and principal, decreases in real terms as price level increases.

    Disadvantages

    1. Debenture interest and capital repayments are obligatory payments. Failure to meet these payments jeopardizes the solvency of the firm.

    2. The protective covenants associated with a debenture issue may be restrictive.

    Term Loans

    Term Loan constitutes a major source of finance for a project, representing a source of debt-capital that is repayable after one year but less than 10 years from the date of the loan. Term Loan is employed to finance acquisition of fixed assets. Term Loans are offered by the All India financial institutions like IFCI, IDBI, ICICI, LIC, UTI, State level financial institutions and Commercial Banks. Term Loan normally carries interest linked to the prime lending rate of the lending institutions, which in turn is based on the prevailing Bank Rate (of RBI). Until a few years back it used to range between 16% to 18%. After the theyear 2000 the progressive reduction of interest ratesall-round, followed successive cuts in RBI's lending rate, presently term loans for eputed corporate borrowers areavailableat or around 10% p.a.

    Raising finance by way of term loan offers the following advantages to a firm:

    1. The effective cost of term loan is lower than the cost of equity or preference capital. This is because the interest payable on term loan being a tax-deductible expenditure results in a lower post-tax cost

    2. In an inflationary period raising funds by way of term loan is advantageous. This is because the burden of servicing term loans, which entails a fixed monetary commitment for interest and principal repayment, decreases in real terms as the price level increases

    As against this, the disadvantage of this source of finance is that the interest payable on term loans and repayment of principal are obligatory payments. Failure to meet these obligations on time can result in acute financial embarrassment. Borrowings by way of term Loans is risky unlike raising capital through equity. Term Loans are of two categories

    1. Rupee term Loans (to finance domestic purchase of fixed assets)

    2. Foreign Currency Term Loans (for import of equipment)


    Other sources of long term capital

    Deferred Credit

    Deferred credit facility is offered by the supplier of machinery whereby the buyer can pay the purchase price in installments spread over a period of time. The interest and the repayment period are negotiated between the supplier and the buyer and there are no uniform norms.

    Unsecured Loans & Deposits

    This is the residual source through which recourse is taken when there is delay in getting other types of long term finance. Unsecured Loans and deposits are secured from family members, relatives, friends and associates and even from other concerns in the group.

    Internal Accruals (Retained Earnings)

    Retained earnings or internal accruals are useful for expansion and diversification of existing projects. Internal accruals arise out of retained balance of profits and also out of provisions made for depreciation,

    Bill Rediscounting Scheme

    SFCs/SIDCs are approved institutions under IDBI bills rediscounting scheme. The Bills rediscounting scheme was introduced in April 1965 by IDBI with a view to helping the indigenous manufacturers to push sales of their equipment by offering deferred payment facilities to purchasers/users.

    Seed Capital Assistance

    SFCs and IDBI are implementing schemes to provide assistance to technically and professionally qualified and experienced entrepreneurs, who have the necessary business acumen and expertise to successfully implement a project but lack resources to meet their own contribution as stipulated by lending financial institutions. The schemes are as under:

    • Special seed capital assistance scheme where funds are provided by respective state government and/or by IDBI. This scheme is also sometimes referred to as state Government Scheme.. Under this scheme the maximum assistance is restricted to 20% of the project cost subject to a maximum of Rs.2 Lacs. The credit risk under this scheme is borne by the SFC/SIDCs disbursing the assistance (SIDC means State Industrial development Corporations)

    • Seed capital assistance scheme of IDBI. The State financial Corporations are allowed 100% refinance by IDBI. The credit risk under the scheme is also borne by IDBI and SFC acts only as an agent for disbursement under the scheme. The maximum assistance per unit under the scheme is restricted to Rs.15 Lakhs.

    SFCs/SIDCs are also approved financial institutions for granting equity loans under National Equity Fund Scheme being operated by SIDBI.

    Sales tax deferment exemption

    This is a scheme floated by different State Governments to encourage setting up of new industries in their States. In many cases sales tax exemption/deferment is allowed to new industries initially for 5 to 12 years. In other cases Loans equal to the amount of sales tax paid on machinery purchased by the new venture and/or sale tax paid on their turn over is provided interest-free.

    Government Subsidies

    Subsidy for new Industries set up in identified backward areas are provided by Central and State Governments, normally up to between 25% to 10% of the project cost. This measure is intended for the development of backward regions and also for the disbursal of industries and creating employment opportunities in interior areas

    Leasing & Hire Purchase

    A lease is a form, of financing employed to acquire the use of assets, through which firms can acquire the economic use of assets for a stated period without owning them. Every lease involves two parties; the owner of the asset known as the lessee, and the owner of the asset known and the lessor. The advantage of leasing finance is that generally the lessee gets 100% finance without providing any margin on his part. Leasing finance organizations in India include private sector non-banking financial companies, some private sector manufacturing companies, many of the term lending institutions and also Subsidiaries of Commercial Banks.

    Hire purchase involves a system under which term loans for purchases of goods are advanced to be liquidated in stages through a contractual obligation. Hire purchase credit may be provided by the seller himself or by any financial institution.


  2. - - - : ( o 0 o ) : - - -


  3. "Working capital must be adequate but at the same time not excessive." - comment

    Working capital is concerned with the management of the current assets. It also includes the current liabilities, to be more precise the financing aspect of the current assets. It is an important and integral part of financial management as short-term survival is a pre-requisite to long-term success. There is a conflict between profitability and liquidity. If a firm does not have adequate working capital, i.e. if it does not invest sufficient funds in current assets, it may become illiquid (i.e. lose liquidity) and thus invite risk of bankruptcy. It will not be able to meet its current liabilities in time and lose its market and good of customers and suppliers. On the other hand, if the current assets are too large, it results larger current liabilities, a good part of which has to be raised through borrowings at market rates, thus adversely affecting profitability.

    The basic objective of working capital is to provide adequate support for the smooth functioning of the normal business operations of a company. A business concern has to operate in an environment permeated with uncertainty and risk. Consequently the quantum of investment in current assets has to be made in a manner that it not only meets the needs of the forecasted sales but also provide a built in cushion in the form of safety stocks to meet unforeseen contingencies arising out of factors such as delay in arrival of raw material, sudden spurt in sales demand etc. Consequently the Company may take a conservative view and hold a large amount of inventory, to ward off risk. Or it may take an aggressive policy towards current assets, and hold the minimum possible inventory to secure the maximise profits, by reducing the cost of working capital borrowings and inventory holding at a barest minimum level. It is therefore apparent that the management of current assets inevitably leads to a trade-off between 'profitability' and 'liquidity'. The inherent conflict can be resolved through a dynamic working capital policy, securing the optimum possible benefits under both the norms. This dynamic policy has to be shaped keeping in view both the financing aspect of working capital, but also the quantum of current assets to be maintained or levels of inventory holding.

    In the normal course of business a company will usually have access to non-interest bearing short-term liabilities such as sundry creditors, accrued expenses and other current liabilities as also provisions toward financing current assets. These are called spontaneous liabilities as they arise more or less automatically in the context of current asset. The difference between the amounts of current assets and spontaneous liabilities needs to be financed by a combination of bank borrowings in the form of cash credit/overdraft arrangement and long-term sources of finance such as debentures and equity capital. Bank borrowings are external source. It is costly, but provide a flexible source of funds, according to seasonal needs. On the other hand the long-term sources such as equity capital is cost free and debentures may be less expensive. Equity capital though appearing to be cost-fee funds, puts the company under the obligation to make profits and declare dividends after paying its tax-obligation.

    For the purpose of financing working capital a distinction is made between Net working capital and Gross working capital. Gross working capital is equal to the total current assets of a Company. Net working capital is defined as the difference between the Gross working capital (total current assets) and current liabilities, including provisions. It is considered that a company should have a favourable current ratio (considered at 1.4), which signifies a ratio of 1 : 1.4 between current liabilities and current assets. It is considered prudent and even insisted by the financing Banks that the quantum of net working capital (the difference between current assets and current liabilities) should be financed by long term internal sources, like equity and debentures and built-in reserves. The balance of gross working capital in the first instance should be financed through spontaneous current liabilities, which are cost-free and the remaining part through bank borrowings or in part through bank

    Holding levels of current assets

    Since working capital is needed to finance holding of currant assets, how much quantity of each item of current assets like raw material, finished goods, cash, receivables should be pegged? For example the Company in order to meet its production plans has to hold some quantity of raw materials, in the form of inventory, as there will be a time lag from the moment of placing an order for raw materials with suppliers till the same are received by the company. The quantum of raw materials needed by the company inter alia depends on its production target, the availability of raw materials in the market, the time-gap between order and delivery, and the economic quantify to be purchased to avail of price benefits, discounts or to reduce transport costs etc. The quantum of finished goods inventory a company carries is basically determined by the degree of accuracy in forecasting sales demand, the ability to meet sudden and unforeseen spurts in the demand for finished goods etc. The Company fixes norms or holding levels for each item of its current assets, based on the working capital cycle, more popularly known as the operating cycle. Thus an ideal working capital management presupposes an efficient inventory or material management, based on norms of holding or levels of holding for each item of inventory expressed as equal to so many days of its sales turnover. Generally in the conditions of Indian industry 15 days finished goods, one month raw-material and one month receivables and 7 days stock in process are considered, but the norms differ from industry to industry. The underlying objective of holding the minimum, but adequate inventory, which underlie the principle of trade-off between liquidity and profitability.


- - - : ( EoP ) : - - -

Previous                 Top                 Next

[..Page updated last on 25.11.2004..]<>[Chkd-Apvd-ef]