Sources of Finance

A tea-estate owner needs ₹50 lakh: ₹30 lakh for new machinery to last twenty years and ₹20 lakh to buy leaf and pay wages for the next three months. Using one source for both would be a mistake. The first step is to sort the sources.

Matching. A good rule is to match the life of the funds with the life of the need. Machinery that lasts twenty years is financed with long-term funds, and leaf stock with short-term ones. Financing a long-term asset with short-term funds forces a refinancing each year, and is risky.

Don’t think ‘external’ always means ‘borrowed’. A new issue of equity shares is an external source, but it is owned capital, not borrowed. The two classifications ask different questions: where the money comes from, and who has a claim on it.

Where it breaks. The time limits are conventions, and books differ. A debenture can be medium-term, and a bank loan can be short, medium or long. Preference shares are called owned capital but carry a fixed dividend and are redeemable, so they sit between owned and borrowed capital.

For exams. Know the five bases and one example for each class, and the difference between owned and borrowed capital.

Time, ownership, origin, nature, control.

Go deeper for practitioners

Internal finance first. Retained profit has no issue cost, no new shareholders and no repayment date, which is why many firms prefer it. The pecking order theory of Chapter 16 builds on this. The catch is that it is limited by how much profit the firm earns, and shareholders forgo dividends.

A decision. A bakery wants to open a second shop costing ₹15 lakh. List which of the five classifications each possible source falls into, and which you would pick.

A founder wants outside money but does not want to be tied to a repayment date. She can sell a share in the business. In return, she gives up some control and some of the profit.

For the firm. Equity gives permanent funds and no fixed charges, but dilutes control and is the costliest source. Preference shares give funds without sharing votes, but the dividend is fixed. Retained earnings need no issue and no outsiders, but are limited to what is earned.

Reserves. A part of profit may be kept in reserves, such as a general reserve. Retained earnings and reserves are internal ownership sources, because they come from the firm’s own profit and do not dilute control.

Don’t call preference shares debt. Preference shares are shares: the dividend is paid out of profit, not as a tax-deductible interest cost, and holders are not creditors. They rank before equity but after debt on winding up. That in-between position is why past exam papers call them a hybrid.

Where it breaks. Equity issued in a bad market sells cheap, and dilutes existing owners more. Retained profit is not free: shareholders could have earned a return by investing the dividend themselves. A firm that keeps too much can be seen as hoarding.

For exams. Remember the features and the nature of each: long-term, owned, with the external or internal tag.

Equity shares the risk, preference shares the order, retention shares nothing.

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Cumulative and redeemable. A cumulative preference share carries unpaid dividends forward, so none can be paid to equity until they are cleared. A redeemable one has a repayment date, which makes it more like debt. Companies law governs the types a company may issue, so check the current Act.

A decision. A family-owned firm needs ₹2 crore and wants to keep control. Which of the three owned sources suits it, and what would it give up?

A trader has sold goods worth ₹1,00,000 on a bill payable in three months, but needs cash today. Waiting is not an option. A bank can pay now, for a fee, and that is only one of many ways to borrow.

Bills discounting, worked. A bank discounts a ₹1,00,000 bill with 3 months to run at 12% a year. The discount is ₹1,00,000 × 12% × 3/12 = ₹3,000, so the trader gets ₹97,000 now. The true yearly cost on the money received is 12.4%, slightly more than 12%, since the interest is deducted at the start.

Lease against hire purchase. A lessee uses an asset for rent and the lessor keeps the ownership, and usually the tax claim for depreciation. A hire purchaser pays by instalments and becomes the owner after the last one, and generally claims the depreciation and the interest. Tax treatment can change, so check the current rules.

Trade credit is not free. Terms of ‘2/10 net 30’ mean a 2% discount for paying in 10 days, otherwise the full amount in 30. Skipping the discount costs about 37% a year, so a firm that uses the full credit period is borrowing at a very high rate.

Don’t treat debentures as shares. A debenture holder lends money and is owed interest whether or not there is profit. A shareholder owns part of the firm. Interest on debentures is a tax-deductible cost; dividends are not.

Where it breaks. Borrowing adds fixed obligations. Too much short-term borrowing to fund long-term assets can leave a firm unable to renew the loans. Factoring and discounting can signal that a firm is short of cash. Check the conditions on security, covenants and the rate.

For exams. Know each source’s term and main feature, the lease and hire purchase difference, and the description of commercial paper and factoring.

Match the life of the money to the life of the need.

Go deeper for practitioners

Cost of the cheapest-looking source. Trade credit seems free, bank overdraft seems flexible, and a lease seems to need no capital. Each has a hidden price: a lost discount, a floating rate, or a lock-in. A firm should compare the full cost, which is the subject of the next chapter.

A decision. A wholesaler is offered 2/10 net 30 terms. She can borrow from a bank at 14%. Should she take the discount by borrowing, and why?