SOURCES OF FINANCE

AND
COST OF CAPITAL

 SOURCE OF FINANCE :-

TYPES OF FUNDS
 LONG TERM FUND - These are the finance needed for the acquisition of fixed assets such
As land and building, plant and machinery, furniture, etc.
Funds spent on fixed assets remain tied up for a long period of time.

 MEDIUM TERM FUND – These are the funds for a period ranging between three to five
Years are required for financing advertising campaign,
Overhauling of machines, tools and equipments etc.

 SHORT TERM FINANCE – These are the funds meet day- to- day finance requirements of an
Organization covering a period of one year,

FINANCIAL REQUIREMENTS AND SOURCES OF FUNDS

Short-term Medium-term Long- term

sources sources sources

1. Trade credit. 1. Preference shares 1. Equity shares
2. Customer‘s advance. 2. Debentures 2. Debentures
3. Installment credit. 3. Public deposit 3. ploughing – back of
4. Discounting of bills. 4. Loans and advances profit
5. Bank finance. from bank 4. Loans from specialized
6. Factoring. 5. Loans from specialized financial institution
financial institutions

1] Short-term sources:- Funds required for meeting day to day

operational expenses are raised through short-term sources such as, trade
credit, customers advance, bank finance etc.

a) Customer’s advances: Represents part of the selling price of bill of

the goods received in advance from the customers when the order is
placed.
b) Trade creditors: Supply of the goods on credit basis for a short
period, constitutes a source of working capital finance.
c) Bill-discounting: Advances granted against the pledge of bills of
exchange to be matured at a future date.
d) Bank over draft: short-term loan granted by the banker to the
current account holders.
e) Cash-Credit: It is a type of short term advance granted by the
banker s which is running in nature and the interest is charged on
actual cash withdrawn.
f) Installment credit: Involves the payment of the sales price of the
goods purchased in terms of installment and ownership is transferred
upon the payment of last installment.
FACTORING: There has been a considerable rise in the volume of
industrial production and sales as result of rapid industrialization. Seller
finds it difficult to push the sales because of severe competition.

Factoring is a method by which a firm gets cash price of

the goods supplied to the customers from specialized agents called
factor. Factoring involves the outright sale of the account receivable to
commercial financing companies by business houses in consideration of
commission payable to them for their service. By purchasing account
receivables from the business concern, the factors assume the credit
risks association with the collection of receivables.

Advantages of factorings:-

1) Benefit to specialized services: - Factors are specialized

financial institutions engaged in purchasing accounts receivables
of business firms and collecting such receivables from the
customers as and when they fall due for payment.
2) Effective credit management: - Factoring facilitates effective
credit management. Factors are the sources of credit
information. They collect and analyze the credit information
relating to the different groups of customers and help the client
in deciding whether to grant credit to the customers or not.
3) Reduced cost of credit collection: - Factoring reduces the
cost of managing and controlling the credit. A business need not
set-up a separate department to look after the credit sales.
Responsibility right from the credit decision to the collection of
 accounts receivables can be entrusted to the factors, on
commission basis.
4) Increased sales: - Factors help in increasing the sales by
purchasing the customers receivable. Sellers are assured of
market for their product by factors.
5) Ensure smooth and unrestricted flow of business
activities: -Factoring enables the business firms to concentrate
more on their important aspects of manufacturing or business
activities rather than on wasting their time and money on the
collection of receivables.

- :Dis-advantages of factoring: -

1) High cost: -One of the dis-advantages of factoring is it‘s high

cost. Factors charge exorbitantly of their service.
2) Sign of weakness: - Creditors and customers consider factoring
as a sign of weakness. Sales of receivable to the factors create an
impression in the minds of the customers and other creditors that
the business concern is experiencing financial difficulties.
3) Selective financing scheme: - As has already been discussed,
factors do not purchase all the accounts receivables of a business
concerns. Selection of accounts depends upon credit –
worthiness, business reputation, integrity, honesty, sincerity, etc
of the customers.
4) Short duration: - Another draw-back of factoring is that, it only
meets short-term financial requirements of a business concern. It
 is nothing but invoice-discounting that matures with a period of 3
to 4 months.

Kinds of factors

Full-factors: - Full factors provide wide range of services in the

matter of collection of receivables. Besides collection of receivables,
they also maintain sales ledger and manage the credit system.

1) Recourse factors: - In this type of factoring, the factors do not

give any protection to the client against the risk of loss due to
bad-debts in the event of failure to pay the debts by the
customers. Recourse is the right of one party to claim the
payment from the second party, if the
Customer fails to pay the amount as agreed.

Right issue: - If an existing company needs

additional funds, it can do so by issuing further
shares or debentures. When the equity shares are
issued to the existing shareholders, the issue is
known as right issue.

NO PAR STOCK: - No par stocks are a peculiar kind of shares

having no face value. Through they are popular in USA, Canada
and UK they are prohibited to be issued in India.
 PLOUGHING-BACK OF PROFIT
A company sets aside a part of its earnings for meeting
future needs. This process of utilizing a part of the profit
of the company for financing the business operations from
time to time is known as ploughing back of profit.

DIFFERENCE BETWEEN SHARES AND

DEBENTURES
SHARES DEBENTURES

1. Share holders are 1. Debenture holders are

owners of the the lenders of the
company. company.
2. Return on shares is 2. Return on debenture
called “Dividend”. is called “Interest”.
3. Share holders enjoy 3. Debenture holders do
voting rights. not have voting
4. Shares are rights.
redeemable only on 4. Redeemable
the closure of the Debenture are
company. repayable on fixed
5. Dividend may or may date.
not be paid on 5. Interest at fixed rate
shares. has to be paid
 6. Shares are not compulsorily.
convertible in to 6. Dentures are
Debentures. converted in shares.
7. Eligible to get bonus 7. Not eligible to get
shares. bonus shares.

OVER CAPITALISATION
When a company‘s rate of earning
is less than justified by its capital, the company was
said to be over capitalized.

UNDER CAPITALISATION
When a company‘s earning rate is
exceptionally high and its real value exceeds the
book value is called under capitalization.

CAPITAL GEARING
Capital gearing refers to the
relationship between owned funds and borrowed
funds. Capital gearing signifies proposition of
different kind of security to the total capitalization.
TRADING ON EQUITY
Trading on equity means
increasing the return on investment of equity share
holders by using the funds on which fixed rate of
interest or dividend has to be to paid. When a firm
desire to trade on equity, it’s a capital will be made
up of equity shares, preference shares and or
debentures.

OPTIMUM CAPITAL STRUCTURE

Optimum capital structure is
one that maintains an ideal ratio between different
type of securities issued by a firm (company)
constituting a total capital that maximizes the
market value of equity shares and minimize the
average cost of capital.

Operating leverage = contribution

EBIT

Financial leverage = EBIT

EBT
Combined leverage = Operating leverage X Financial
leverage

WORKING CAPITAL: -
A firm needs capital for
different purpose. A part of it is permanently used in
business whereas, other part of it is kept aside to
meet day to day financial requirements.

TYPES OF CAPITAL

1. Fixed capital
2. Working capital.

CLASSIFICATION OF WORKING CAPITAL

1. Gross working capital: - The gross working capital

consists of total current assets. It represents a
company’s investments in current assets.
2. Net working capital: - Net working capital is defined
as the difference between current assets and current
liabilities.
3. Permanent working capital: - It refers to the current
assets that are required to be maintained continuously
throughout the year to carry on the business operation.
It represents that part of the working capital which
remains permanent in the business is called permanent
Working capital.

PRODUCTION CYCLE: - The time taken for converting

raw materials into final product is known as production
cycle.

BUSINESS CYCLE: - Business increase during boom

period and decrease during the period of depression.

CAPITALISATION
Real value of share=