By Yashu Bansal, Chanakya National Law University, Patna
“Editor’s Note: This paper studies the financing decisions in a company. It discusses the concept of a joint stock company, the nature and importance of financing decisions and capital planning. The paper analyses the internal and external short-term and long-term sources of finance available to a company. Finally, it compares two most important sources of finance for a company- debt and equity.”
A company can be defined as an “artificial person”, invisible, intangible, created by or under Law, with a discrete legal entity, perpetual succession and a common seal. It is not affected by the death, insanity or insolvency of an individual member. Because companies are legal persons, they also may associate and register themselves as companies – often known as a corporate group. When the company closes it may need a “death certificate” to avoid further legal obligations.
Finance is the life blood of business. Every business enterprise requires finance to start its operations, to carry on its activities and to expand and grow. The availability of finance determines the size and scale of operations of any business. Proper use of funds is necessary for profitable working and sound health of the business. Adequate funds enable a business enterprise to buy the necessary assets and to meet its liabilities in time. Thus, financing is the process of planning, acquiring, utilizing and controlling the funds used in any kind of business.[i] Therefore financing decisions are those day-to-day decisions about how to obtain funds for the business and when obtained, how to use them efficiently. It includes investing the capital. Capital is that investment in the business, which is for the purpose of earning profits. There can be three types of business ownerships who need to finance themselves. Sole traders are the individuals who start a business, at a small scale, requiring a limited amount of capital. Next, partnership is the agreement between two or more individuals to start a business with the profits and losses being shared in a decided ratio. Lastly, a joint stock company is a voluntary association formed by some persons for profits with a capital divided into transferable shares, having a corporate body and a common seal. Financing decisions play a significantly great role in all these forms of business. They have a major hand in the successful running of the business.
Finance can be raised using internal and external sources. Internal sources can be used by increasing the sales and the revenue to have an impact on the overall profits, by using retained profits in the business and by selling off the assets in the business. The external sources include issuing all kinds of shares-ordinary, preference, bonus, right and new and issuing long term debentures.
Every company has its own balance sheet prepared at the end of the accounting period. Balance sheet is the financial statement of a company, which shows the amount, and nature of business assets, liabilities and owners’ equity as on a particular date. Financial decisions are the decisions concerning the liabilities and the stockholders’ equity side of the balance sheet such as decision to issue bonds.[ii] Financing is the process of deciding the source, use and measures to control the funds in any kind of business and to see to it that the funds are put to its best use so as to gain maximum advantage for the company.
Finance can be of two types: personal finance and business finance. Personal finance is the type of finance, which is required for an individual from himself. The finance can be from his own pocket or can be a loan from his friends and relatives. The internal source of finance can also be in the form of grants from the Government if entitled to some benefits. It may also be any form of personal gains and gifts or increase in the revenue. It is mostly used for the contribution to capital for sole proprietorship business. Short-term loans can be obtained from commercial banks. Long-term loans for fixed assets are available from State Financial Corporations and other financial institutions. Central and State Governments provide special finance assistance to small-scale unity in order to encourage entrepreneurship and self-employment. A sole proprietor may also buy raw materials and finished goods on credit from the suppliers. [iii]
On the other hand, business finance is the funds required by a business entity to function smoothly. It also has some similar sources of finance as of personal financing sources. It needs to take up loans from private individuals, venture capitalists and by the means of micro loans. Long term and short term finance are required for the financing of business entities. The concept of long term financing includes issuing of equity shares, issuing of preference shares, issuing of debentures, taking loans from specialized financial institutions and ploughing back of profits. Short term finance refer to the public deposits, trade credit, bank credit and so on.
Importance Of Financing Decisions
Financing decisions are the decisions in regard to the use of funds in any organization in the best possible way. Financial decisions are the decisions concerning the liabilities and the stockholders’ equity side of the balance sheet such as decision to issue bonds. Every organization has several day-to-day decisions to be made for the smooth functioning of the organization. From the buying of assets to the selling of products, from the hiring of workers to the firing of employees, all the decisions are very important and crucial. However, financing decisions play a very important role in an organization. Planning involves insight into the economic condition of your country and its future. Be it a developing or developed country, finance can be used as a tool to shape a country’s economic well being. For developed nations it can help to stabilize the growth at the maximum level, and for an underdeveloped economy it can change the face of overall financial condition by effectively applying the tools of finance. Finance is such a thing that can’t be substituted by anything, so make sure you use your finances in the proper order, so that you can secure your future.[iv]
While taking financial decisions, many precautions have to be taken since these decisions are very important for the following reasons:
Long Term Growth And Effect
Financing decisions affect the company in the long term. It can be said that these decisions are more important than any other decisions regarding the company. Greater precise the financing decisions, greater profitability of the company in the long run. These decisions concern the purchase of long term assets as well and these long term assets are helpful in the production of goods. These funds are used in every sphere of the company. It has to be decided very wisely since these decisions will have its impact on the company for the many more years to come and even then, these decisions will hold value.
Large Amounts Of Funds Involved
Financing decisions have a large sphere to work in. It includes capital budgeting and investing the funds. It is therefore understood very clearly that the amount of money required for functions like capital budgeting cannot be small in any case. It definitely has to be a large amount of money, which is invested into a company, and if the decision turns out to be wrong, it will be very devastating for a company. Investment is a scarce resource and investors are very hard to find in today’s age of global marketing and financing. One wrong financing decision can bring the company to a breakdown state and to regain that position is not an easy task. Thus, financing decisions have to be taken very carefully since they involve large amounts of funds.
Risk is the probability or threat of damage, injury, liability, loss, or any other negative occurrence that is caused by external or internal vulnerabilities, and that may be avoided through preemptive action.[v] Every company is afraid of losses but it takes up risks at every stage of the company since risk is involved in every sphere of life. Financing decisions are also full of risks. At every step, be it planning or executing, financial decisions involve a lot of risks. There can be two reasons for this vast amount of risk. Firstly, these decisions are long-term decisions which will have its impact on the company for years to come and as such expected profits for several years are to be anticipated and this estimation involves risk. Secondly, these financial decisions involve large amount of funds, which cannot be gained again if lost once. This huge risk makes it very important that the financing decisions of a company should be taken very carefully and after proper evaluation of all the circumstances, the risks involved, the advantages and an estimation of losses if incurred.
Financing decisions should be taken very carefully since they have a very important feature-they are irreversible. Once the funds are invested into the company, any power cannot take out the investment and bring back the funds. This is what is meant by saying that the financing decisions are irreversible. Nature of these decisions is such that it cannot be changed so quickly. For instance, if an individual invests lots of money in setting up a cotton mill and soon after setting up the cotton mill, a pan to change it into a textile mill. Then the old machinery and other fixed assets will need to be changed and thus will have to be sold at a throwaway price. An entire new set up will be required and yes, new investments and funds will also be required. In doing so, heavy loss will have to be incurred.
Capital is the investment in the business for the purpose of earning profits. In any business, capital is used for both production and distribution purposes. Capital requirements differ according to the size and nature of the business firms. A suitable capital plan is essential for the success of every business enterprise. It should provide for:
- Accurate estimate of the total capital requirements
- Selection of the right methods or sources of finance for raising the estimated capital
Capital can be of two types: fixed capital and working capital. Fixed capital refers to the funds required to purchase fixed assets. Fixed assets are meant for generating income. These assets are used permanently for business operations. Fixed capital provides the cornerstone of business. It is raised through long term sources of finance such as shares, debentures and retained earnings and long term loans. There are several factors that decide the financing of the capital.
Nature Of Business
The amount of fixed capital varies from companies to companies. A manufacturing company requires heavy investment in fixed assets such as land, building and plant and machinery whereas trading concerns require less investment in fixed capital.
Size Of The Business
The scale of operations also decides the amount of finance to be invested in the fixed capital. A large sized enterprise requires larger funds than a small scale firm. For instance, a giant company like TISCO requires larger funds than any mini steel plant. A large investment is required for a high volume of production.
Nature Of Products
A company manufacturing capital goods like machinery and engines will require higher amount of funds than a company producing consumer goods like hair oil and soaps. Similarly, firms operating in heavy industries like ship-building require greater investment than light industries like sugar mills.
Method Of Production
A company employing capital-intensive technique of production such as automatic machinery requires higher investment than a labour intensive company employing workers. A power loom requires more fixed capital than a handloom unit.
Diversity Of Product Line
A multi-product company manufacturing diversified products requires more investment in the form of fixed capital than a company manufacturing a single product. Similarly, a company manufacturing each part of finished product by itself requires more investment than a firm which buys component parts from outside and simply assembles them.
Mode Of Acquiring Fixed Assets
A company which purchases assets on cash down basis requires huge amount of fixed capital. On the other hand, companies which purchase fixed assets on credit or on lease require lesser investment in the fixed capital.
These are the factors which determine the amount of funds to be utilized for investment in the fixed capital. The other type of capital is working capital. Working capital means the capital invested in working assets or current assets such as cash, stock of goods, debtors, short term investments and so on. It represents the liquid funds, which are required in the day to day operations of a company. [vi] Working capital is also known as the circulating capital or revolving capital because it keeps on circulating or revolving in business. It is invested, recovered and reinvested repeatedly during the operating cycle of business. The operating cycle involves conversion of cash into raw materials, raw materials into work in progress, work in progress into finished goods, finished goods into receivables and receivables into cash.
WORKING CAPITAL=CURRENT ASSETS –CURRENT LIABILITIES
There are several factors that control the amount of funds to be invested in the working capital of any company.
Nature Of The Business
Manufacturing companies require considerable working capital as they have to build up a stock of raw materials and finished products. On the other hand, public utility undertaking require less working capital as they do not have maintain an inventory.
Size Of Business
Larger companies require larger investment for the working capital whereas smaller companies require less capital as working capital.
This means the time involved in the production of the goods. Longer is the time gap between the purchase of raw materials and the production of the finished goods, higher is the need for working capital and vice-versa.
When a liberal credit policy is followed, more working capital is required. On the contrary, smaller working capital is needed in case of a tight credit policy.
Better utilization of funds leads to reduction in costs and improvements in the profitability. As a result, the need for working capital is reduced. High profit margins and flow of regular income from sales also reduce the amount of working capital in the company.
Working capital requirements of business which are subjected to seasonal variations are comparatively higher during a particular season.
Cyclical changes create emergency demands for investment in working capital. During boom period there is no need for larger working capital to support higher volume of business. During depression, declining sales and slow collection from debtors, the company will have idle working capital locked up in stocks and debtors. Therefore, larger finance will be required.
Sources Of Funds In A Company
Funds and financing are basically the management of large amounts of money which is for investment in the company. Utilizing these funds in the best way is the work of the finance department and financing decisions are the decisions regarding these funds, from where to acquire them and where to invest them. The finance can be basically from two sources, internal and external.
The internal sources of funds are those finance which are raised from within the company. These sources are not acquired from any external sources. They can be raised in the following manners:
Generating Increasing Sales
When firms decide to increase their production of goods and products, a rapid increase in their revenue is experienced. This excess revenue is used to bring in revolutionary changes in the company. It is invested in the company in itself for the growth and improvement of the company.
Use Of Retained Profits
This method is also called ploughing back of profits. This refers to the process of retaining a part of the net profits year after year and reinvesting the same in business. Well established companies often use undistributed profits to meet a part of their financial requirements. This source is also called ‘self financing’ as it is an internal method of finance. Generally, more the net profits of a company, greater is the capacity to plough back profits.
Sale Of Assets
Many companies sell off their assets to gain some funds for investment in their companies. But this method can be a double edged sword since it can reduce the capacity of the companies. However, this method of internal financing is used by companies very rarely when there is a great scarcity of funds.
The external sources are those sources of funds which are not a part of the company. They are sources outside the firm, may be the public or the Government. The external sources of funds generally shares, debentures, loans, credit facilities and so on. The external sources can be divided into long term and short term sources.
Long Term External Sources
Long term sources are those sources which have funds invested in a long term perspective. The money is invested for many years and for a greater purpose. Some of the major investments in the long term form are:
Issues of shares is the most important method of raising long term funds. Share refers to a share in the share capital of a company. It is one of the units into which the share capital of the company can be divided. It indicates the interest in the assets and the profits of a company. A public company can issue shares of two types: preference shares and equity shares. Preference shares are the shares which carry certain privileges or preferential rights-both regarding the dividend and the return of the capital. Dividend at a fixed rate must be paid on preference shares before any dividend is paid on the equity shares. Preference shareholders must be paid back their capital before equity shareholders. Equity shares are those shares which carry no preference rights or priority in the payment of the dividend and in the repayment of the capital. Dividend on equity shares is paid after paying dividend on preference shares.
Debentures denote borrowing by a company and represent its loan capital. Debenture holders are creditors of the company. A debenture is a document or certificate issued by a company as proof of the money lent to it by the holder. It is an acknowledgement of debt as well as undertaking to repay the specified sum with interest on or before the prescribed date.
Loans From Financial Institutions
The Government of India had set up several special institutions in the country to provide long term and medium term finance to business enterprises. These institutions or development banks have become a major source of finance for floatation of new concerns as well as for the modernization and expansion of the existing concerns. They provide finance for both in the form of debt and debt. These specialized institutions have become the biggest source of finance for industries in India.
Ploughing Back Of Profits
This refers to the process of retaining a part of the net profits year after year and reinvesting the same in business. Well established companies often use undistributed profits to meet a part of their financial requirements. This source is also called ‘self financing’ as it is an internal method of finance. Generally, more the net profits of a company, greater are the capacity to plough back profits.
Short Term External Sources
Short-term sources are those sources which have funds invested in a short-term perspective. The money is not invested for many years. It is mainly used to cover fluctuations in cash flow. Some of the major investments in the long-term form are:
Public deposits refer to the deposits of money made by the public with non-banking companies. These deposits represent loans from the public including employees and shareholders of the company. The system of public deposits originated when banks were not well developed in India. Companies find it cheaper than loans from banks and financial institutions.
These are all forms of loans obtained from the banks, loans and advances, cash credit, bank overdraft and discounting of bills. A loan is a direct advance made in lump sum which is credited to a separate loan account in the name of the borrower. It is a revolving credit agreement under which a borrower is allowed to borrow up to a certain results. Unlike a loan, it is a running account from which the amounts can be withdrawn from a time to time. When the cash credit is not backed by any security, it is known as clean cash credit. In case of secured cash credit, the borrower is required to give security in the form of tangible assets or guarantees.
In certain cases, manufacturers or suppliers of goods require the customers to deposit an advance payment before the delivery of goods. At the time of delivery of the articles, the advance is adjusted against the price of the articles. This is yet another form of short-term external form of finance.
Equity vs. Debt
Equity Shares: Equity shares are those shares which carry no preference rights and priority in the payment of the dividend and the repayment of the capital. Its merits are as follows:
- There is no burden on earnings because the dividend on such shares is payable only at the discretion of the management, subject to the reality of adequate profits.
- Equity capital is a permanent capital. It is to be refunded only at the time of the winding up of the company and that too if any surplus is left after paying off all the liabilities.
- Equity shares create no charge or mortgage on the assets of the company. Therefore it is a good source of finance.
Equity shares have certain disadvantages as well. Some of their demerits are:
- A company cannot issue shares in excess of authorized capital in the Memorandum of Association. Therefore it is inflexible.
- There is no trading on equity even when the entire share capital is raised through equity shares. Therefore, it is harmful for the company.
- The cost of issuing equity shares is higher than the cost of issuing other types of securities.
Preference Shares: Preference shares are the shares which carry certain privileges or preferential rights-both regarding the dividend and the return of the capital. Dividend at a fixed rate must be paid on preference shares before any dividend is paid on the equity shares. Preference shareholders must be paid back their capital before equity shareholders. Some of its advantages are:
- It is an appeal to cautious investors who look for reasonable safety of their capital along with a fixed but higher return than obtainable on debentures.
- Preference shares are no fixed burden on the profits and finances as dividends are payable only out of profits.
- Rate of dividend on preference shares is fixed. When the company’s earnings rise, the company can pay higher rates of dividends to equity shareholders. They are therefore an economical source of finance.
Preference shares have certain demerits as well. Some of them are:
- The cost of raising finance from preference shares is more than raising finance from debentures. It is thus a costly affair.
- Preference shares have little appeal to investors. Cautious and conservative investors prefer debentures over preference shares.
- The dividend to be paid on preference shares has to be paid at a fixed rate before any dividend is paid on equity shares. It therefore becomes a burden on the company.
Debentures: Debentures denote borrowing by a company and represent its loan capital. Debenture holders are creditors of the company. A debenture is a document or certificate issued by a company as proof of the money lent to it by the holder. It is an acknowledgement of debt as well as undertaking to repay the specified sum with interest on or before the prescribed date. Some of its merits are:
- It is an appeal to cautious investors who prefer safety of investment and a fixed return. In tight money conditions, debentures are the best source of finance.
- It is an economical source for the company. A company can raise funds from debentures at a relatively low cost. They can be sold more easily than shares.
- Debentures provide a freedom of management to the company since they do not carry voting rights. Any company can raise funds through debentures without weakening or strengthening the control of the existing members.
Debentures have certain disadvantages as well. Some of its demerits are:
- Debentures form a permanent burden on the company. Interest has to be paid every year irrespective of the profits and that becomes a burden
- Debentures lead to a reduction in dividend. During times of low earnings, very little profits may be left after the payment of interest on debentures. Then the company may not be able to pay enough dividends and thus the market values of its shares may go down
- Debentures are a reduction in the credit standards of the company. A company which has issued large amount of debentures has very low credit worthiness. Borrowing from banks and financial institutions become difficult then.
Every business enterprise requires finance to start its operations, to carry on its activities and to expand and grow. The availability of finance determines the size and scale of operations of any business. Proper use of funds is necessary for profitable working and sound health of the business. Adequate funds enable a business enterprise to buy the necessary assets and to meet its liabilities in time. Thus, financing is the process of planning, acquiring, utilizing and controlling the funds used in any kind of business.[vii]
Every organization has several day-to-day decisions to be made for the smooth functioning of the organization. From the buying of assets to the selling of products, from the hiring of workers to the firing of employees, all the decisions are very important and crucial. However, financing decisions play a very important role in an organization. Planning involves insight into the economic condition of your country and its future. Be it a developing or developed country, finance can be used as a tool to shape a country’s economic well-being. For developed nations it can help to stabilize the growth at the maximum level, and for an underdeveloped economy it can change the face of overall financial condition by effectively applying the tools of finance. Funds and financing are basically the management of large amounts of money which is for investment in the company. Utilizing these funds in the best way is the work of the finance department and financing decisions are the decisions regarding these funds, from where to acquire them and where to invest them. The finance can be basically from two sources, internal and external.
Thus the financing decisions are very important and crucial for every company to fulfill its goals and to achieve its aims.
Edited by Kudrat Agrawal
[i] Gupta, C.B: ISC Commerce, S. Chand, 2012
[ii] Campbell R. Harvey, Hypertextual Finance Glossary, available at http://people.duke.edu/~charvey/Classes/wpg/bfglosf.htm
[iii] Gupta, C.B: ISC Commerce, S. Chand,2012
[iv] Importance of Finance, available at http://www.buzzle.com/articles/importance-of-finance.html
[v] Dictionary, available at http://www.businessdictionary.com/definition/risk.html
[vi] Gupta, C.B: ISC Commerce, S. Chand, 2012
[vii] Gupta, C.B: ISC Commerce, S. Chand,2012