Chapter 2

SOURCES OF FINANCE

Finance is the life blood of business. The business cannot run efficiently if it dose not
have adequate finance to meet the requirements of the business. The business
needs finance to satisfy its long term requirements and its short term requirements.
The short term requirements are for meeting the working capital needs of the
business while the long term funds are necessary for meeting the fixed capital
requirements of the business. The long term needs are classified into two parts i.e.
the medium term requirements and the long term requirements. The former includes
the funds required for a period between 1 to 5 years and the latter includes the funds
required for a period exceeding 5 years.

The sources form which the business meets its financial needs are classified under
three broad headings (a) According to period (b) According to ownership (c)
According top the source of generation,

Classification of sources of finance

According to period According to ownership According to source of

generation

Long term sources Owned capital like share Internal sources

like shares, debentures capital. Like retained

loans etc. Borrowed capital like earnings and

Short term sources debentures, public deposits, depreciation funds etc.

like the advances, loans etc External sources

trade credits, public securities, shares,

deposits etc. debentures etc.

Classification of the source of finance is done according to the ownership and the
same is made on the basis of the rights given to the investor. The investors who
invest money in equity shares and preference shares get the ownership rights of the
company. Thus they become the owners of the company. However, the investors
who invest the money in debentures, loans, public deposits etc get the right of a
creditor of the company; those do not become the owners of the company.

The classification of the finance done according to the source of generation of funds
is on the basis of the internal sources which basically consist of the retained
earnings created form the accumulated profits of the company and the depreciation
funds which are used to replace the concerned asset. Thus this proves to be an
important source of finance for the corporate enterprise in India. The external source
basically consist of the long term sources of finance like the shares, term loans,
debentures, bonds, warrants, options, leasing, hire purchase, venture capital, project
financing etc.

EXTERNAL SOURCES OF FINANCE

Share Capital: -

The most commonly used method in India for raising long term finance is by issue of
shares. Ordinary shares represent the ownership position of the company. A share
may be defined as one of the units in which the share capital of the company has
been divided. Ordinary share holders are the legal owners of the company. The
person holding the share is called the share holder. He gets dividend from the
company as a consideration for investing the money into the company. The payment
of the dividend is not compulsory on the part of the company. The board of directors
has the right to recommend the rate of dividend in the general meeting before the
share holders. The ordinary shares is a permanent source of capital as it is not to be
repaid back in the life time of the company i.e. these shares do not have any
maturity date. The ordinary share capital is also called the Equity Share Capital.

The Equity Share Capital appears on the Liability side of the Balance Sheet as
Authorized Share Capital, Issued & Paid –Up share Capital.
Authorized share capital is mentioned on the first line of the liability side of the
balance sheet. This means, it is the maximum amount of capital which the company
can raise from the share holders. The company can change the authorize share
capital by making changes in the memorandum of association and following the
other legal formalities.

The part of the authorized share capital which is offered to the public or to the share
holders is called the issued share capital. The part of the issued share capital which
is accepted by the share holders is called the subscribed share capital. The amount
of the subscribed share capital which is actually paid by the share holders is called
the paid-up share capital.

There are basically two types of shares

 Equity shares
 Preference shares

TYPES OF SHARES

Preference shares Equity shares

Cumulative Shares Deferred Shares

Non-cumulative Shares Qualified Shares

Participative Shares Bonus, Mini Bonus & Right Shares

Non-participative Shares Sweat Equity Shares

Redeemable Shares

Non-Redeemable Shares

Convertible shares

Non-convertible shares

Preference shares: -
 The preference shares are those which carry a lot of preferential rights over other
classes of shares are called the preference shares. These shares have preferential
rights in following aspects

 The preference shares get a dividend at a pre determined fixed rate.

 The preference shares get a preference in repayment of the capital in case
of the winding up of the company as compared to other types of shares.

There are six types of preference shares. They are categorized on the basis of
accumulation participation and redemption

Accumulation: -

The category of accumulation states that the preference shares can or cannot
accumulate the dividends for years and then receive it when the company makes
profits. Most of the Preference shares in India are of cumulative type. It is a protective
device for the Preference share holders.

Under this category there are two types of Preference shares,

Cumulative and

Non-cumulative.

In case of the Cumulative Preference shares the dividend goes on accumulating unless
it is paid. The accumulated arrears have to be paid before anything else is paid out of
the profits to the share holders of any other class.

In case of the Non-cumulative Preference shares the right to claim the dividend lapses if
there are no profits in a particular year. Such Preference share holders are not entitled
to get the dividends due to inadequate profits in that particular year.

Participation: -

This category states that participation of the preference share holders in the surplus
profits remaining after the payment of the dividends to the equity share holders at a
fixed rate as determined by the company’s articles of association.

Under this category there are two types of Preference shares

Participating
Non- participating.

The Participating Preference shares have the right to get a share in the surplus profits
of the company. However the Non-participating preference shares are entitled for
receiving dividends only at a fixed rate these cannot participate in the surplus profits of
the company.

Redemption: -

The category of redemption states the repayment made to the Preference share holders
during the life time of the company. Under this category there are two types of
Preference shares.

Redeemable

Irredeemable,

The Redeemable Preference shares are redeemed during the life time of the company.
The Irredeemable Preference shares are those which are redeemed only at the time of
liquidation of the company.

The Irredeemable Preference shares are also called as the ‘Perpetual shares,’ these
shares do not have a maturity date. In India the redeemable preference shares are not
often redeemed as there are no serious penalties for the violation of the redemption
feature.

Convertibility

This category states that the Preference shares can be converted into equity shares,
whenever the management needs it. It is only done once. Under this category there are
two types of Preference shares.

Convertible and

Non-convertible shares

The convertible preference shares can be converted into equity shares when ever
needed by the company.

The non-convertible preference shares cannot be converted into equity shares by the
company.

Features of Preference shares: -

 1. The Preference share holders have a preference in the receipt of the claims of
the dividends before the equity share holders and they also have a preference
before the equity share holders in receiving the amount at the time of liquidation
of the company.

2. The returns paid by the company to the Preference shares are in form of
dividend paid out of the profits earned. But the rates of dividend are pre-fixed and
are pre-communicated to the share holders.

3. The investors do not become the absolute owners of the company as the
preference share holders do not get the voting rights of the company. If the
dividends are not paid for a period of consecutive two years or for an aggregate
period of three years out of the preceding six years then the preference share
holders have right to cast a vote in the general meeting of the company. These
rights are called as the contingent voting rights.

4. The investment in preference shares is risky on the part of the company; but, the
same is preferable and less risky investment for the investors as the investors
are assured of the dividend.

5. The preferences shares can be redeemed if the have a maturity date. They also
can be partly or fully converted into equity shares or debentures if the dividend
rates are low.

6. The participating feature on the preference shares gives the share holders a right
to participate in the surplus profits of the company; due to this the share holders
may get higher rates of dividend than the prescribed rate.

7. Due to the call feature on the preference shares the company can buy-back the
preference shares at a call price. This price can be more than the par value of
the shares; it is called the call premium.

Merits of Preference shares: -

1. Financing through preference shares has a financial flexibility as payment of

dividend is not a compulsion, nor a legal obligation. It the earnings of the
company deteriorate, the company can omit to pay or postpone the payment of
the dividend to the preference share holders.
 2. The preference shares do not have a final maturity. (if they are not redeemable
preference shares) Thus these funds provided are a sort of a perpetual loan for
the company giving the company financial flexibility.

3. The preference shares add to the equity base of the company thus strengthens
its financial base for the company. It also enhances the ability of the company to
borrow in the future.

4. Preference shares are a sort of cushion to the debenture holders and thus save
the company from paying high rates of interest.

5. Issuing preference shares dose not create a charge on the assets of the
company, so the assets can be utilized for raising additional funds for the
company.

6. In absence of the participating feature mentioned in the articles of association of

the company the preference shares are entitled for a fixed rate of dividend so, its
liability is limited, thus these funds can be used for increasing the overall return
on investments by taking advantage of the trading on equity.

7. Issuing of the preference shares dose not dilute the pattern of control of the
company because as compared to the equity shares the preference shares have
less voting rights, the preference share holders have voting rights only on the
resolutions which directly affect them.

8. Financing through preference shares is much cheaper than financing through

equity shares.

9. The company can utilize huge funds at its disposal by redeeming the redeemable
preference shares as per the provisions of the company’s act 1956

10. Preference shares are a good investment opportunity for those investors who
want high rate of return and comparatively lower risk.

Demerits of Preference Shares: -

1. The major disadvantage is issuing preference shares are that the preference
shares dividend is not deductible as expense for tax purpose out of the profits of
the company; but company has to pay tax on dividend distribution. As a result the
 explicit cost of financing is double as compared to the financing through the
debentures.

2. If the preference shares are cumulative the arrears of the dividends have to be
cleared before anything can be paid to the equity share holders of the company.

3. The preference shares dilute the claim of the equity share holders of the
company.

4. If the dividends are paid to the preference shares at the pre defined rates in spite
of lower profits for the company, to maintain their position in the market, this may
lead to the insolvency of the company.

EQUITY SHARES

The shares which are not preference are called Equity or ordinary shares. These
shares do not have any preferential rights. The owners of the shares are called the
share holders and they are the part owners of the company like the Preference share
holders. They rank after the preference shares in getting the dividend out of the profits
earned by the company and also in receiving the repayment of the capital in case of
company’s winding up. When the company is being formed the company first issues the
shares to the promoters, the further financial needs are satisfied by the friends and the
relatives. The financial needs arising after this are satisfied by the Initial Public Offering
(IPO). Further to this the needs are satisfied by Issues or Offerings.

Methods of issuing Equity shares

The equity shares can be issued at par, discount and at premium.

 Issuing the shares at par means issuing the shares at the face value. There is no
restriction for the regarding the issue of shares at par.

 The company can issue shares at premium i.e. for a value which is higher than
the face value of the shares; the premium can be for cash or for considerations
other than cash. According to the companies act 1956, and as per section 78,
the amount collected by the company as premium has to be transferred to the
securities premium account and has to be utilized for the following purposes:

1. For issuing fully paid bonus shares to the members of the company
2. For writing off the preliminary expenses of the company.
 3. For writing off the expenses on commission paid, discount allowed on the
issue of the shares and debentures of the company.
4. For providing the premium payable on the redemption of the redeemable
and irredeemable preference shares and debentures.

The company can issue shares at discount i.e. for a value less than the face value of
the share, subject to the following conditions laid down in the company’s act 1956
under section 79

1. Shares to be issued at discount must be of the class already issued.

2. The issue of shares must be authorized by an ordinary resolution of the
company.
3. The issue must be pre-sanctioned by the Company Law Board (CLB).
4. The resolution must specify the maximum rate of discount, which must not
exceed 10% unless the board is of the opinion that higher rate of discount,
must be allowed in a special case.
5. Shares can be issued at a discount only after one year of commencement
of business by the company.
6. The issue must take place with in two months of the sanction received
from the Company Law Board. If the issue does not take place with in the
specified time, then the time has to be further extended.
7. Every prospectus must disclose the details of the discount allowed on the
issue.

The above restrictions are for the issue of shares and not for the issue of
debentures as they do not form a part of capital fund of the company.

Features of Equity shares: -

1. The investors in the Equity shares are the real owners of the company. As
such the share holders share the risk and reward associated with the
company. These are entitled for the residual profits of the company after
paying all the claims of the outsiders and the preference shares of the
company.

2. Funds raised by way of equity shares are available on a permanent basis.

They are not to be repaid in the life time of the company. The repayment
is required only at the time of winding up of the company.

3. Funds raised by way of equity shares are available to the company on

unsecured basis i.e. the company dose not offer any security to the
investors for the equity shares.
4. Returns which the company pays to the equity share holders are in form
of dividends. The rates of the equity share holders are not fixed, it depend
on the profits earned by the company. The dividends are declared in the
Annual General Meeting. However, the company is under no obligation to
pay the entire residual profits to the equity share holders, the profits can
be retained in the company as reserves.

5. The Equity share holders may not compel the company to pay the
dividends; but, these enjoy the right to maintain the proportionate interest
in the profits, assets and control of the company. If the company has to
issue additional equity it is under legal obligation to issue the additional
equity shares to the existing share holders first before going to the open
market as a general offer. This is called as the “Pre-emptive right.”

6. As the company does not commit anything to the equity share holders this
source of finance is a long term risk free source.

7. Investing in the equity shares is a risky investment for the investors, so

these investors are granted voting rights. By exercising the voting rights
they can indirectly participate in the management of the company.

8. The equity share holders have a right to attend the Annual General
Meeting of the company, elect the Board of directors and cast a vote on
every resolution of the meeting.

9. Each share holder is entitled to cast one vote for every share held by him
in the company. However, due to the recent amendments in the
company’s act 1956 it may be possible for the company to issue the equity
shares with disproportionate voting rights. Share holder can appoint a
proxy while attending the Annual General Meeting.

10. In financial terms the equity share capital is a costlier source available for
the company.

11. The equity share is a transferable property i.e. it can be transferred and
sold from one person to another.

12. The liability of the equity share holders is limited to the extent of the share
capital of the company.
Benefits of Equity shares: -

To the Company

1. Financing through Equity shares dose not impose any burden on the
company, as the payment of the dividend depends on the availability of
the profits and on the discretion of the Directors of the company.

2. Capital raised through the equity shares is sort of a perpetual loan to the
company as it is not repayable during the life time of the company. It is
repaid only at the time of liquidation of the company.

3. The company does not face risk to magnify losses in the periods of
adversity as the payment of any dividends is not a compulsion and the
dividend decisions can be postponed. It provides the company with
sufficient financial flexibility in utilization of its profits and the funds.

To the Investors

4. As per the law, though the equity share holders are the owners of the
company the liability is restricted to the extent of the face value of the
shares purchased, the personal properties of the investors are not at
stake. Even if the company fails to fulfill the contractual obligations.

5. A possibility of getting higher returns is always in the case of the equity

shares as the investors get returns in form of dividends and bonus shares
from the company. Secondly the capital appreciation can be received by
the investors by selling the equity shares in the secondary market. So, the
equity share is an attractive investment for the investors who are ready to
take risk.

Disadvantages of equity shares: -

1. Financing through equity shares is costly as compared to the financing

through Preference shares as well as Debentures as the expectations of
the equity share holders is high since the risk taken by them is high.
 2. The dividend on the equity shares is not deductible as an expense out of
the profits for taxation purpose of the company.

3. The investors of the equity shares enjoy the voting rights to control the
affairs of the company; so, the management is under constant danger of a
group of shareholders coming together for manipulating the management
of the company.

4. There is a statutory restriction for the institutional investors of the equity

shares and as most of the investors are of the category of institution their
investments are restricted.

5. Excessive reliance on financing through equity shares reduces the

capacity of the company to trade on equity. This may ultimately lead to
overcapitalization of the company.

6. The cost of underwriting and distributing the equity share capital is

generally higher than the preference shares and debentures.

Types of Equity shares: -

1. Deferred shares: - The shares which are issued to the founders or the
promoters of the company are termed as differed shares or founders
shares. According to the amendments made in the Company’s Act 1956
such shares can be issued only by a private limited company which is not
a subsidiary of a public limited company. These shares rank last in getting
dividends. If the company makes less profits these category of shares do
not get any dividend. But if, the company makes extraordinary profits
these shares get even more dividend than the Equity or Preference
shares. Some times these category of shares are given to the
underwriters for there services.

2. Bonus and Right shares: - Issue of the shares to the share holders of
the company by capitalizing the reserves of the company is called as a
Bonus Issue. It is a gift from the company to the share holders, and is
paid out of the free reserves created by genuine profits and the share
premium collected by the company by way of cash only. These shares can
be fully or partly paid up, the partly paid up bonus shares can be termed
as a Mini-right issue. The bonus issue is declared by the company with
some motives like bringing down the share prices to the absolute terms
and to ensure a continuous investors interest. The bonus issue increases
 the number of shares but, the proportional ownership does not change.
The magnitude of the bonus issue is to be decided by taking into account
the certain rules such as, the residual reserves after the proposed
capitalization must be at least 40% of the increased paid-up capital, before
giving bonus to the share holder the company must see that the existing
shares are fully paid-up and the gap between two bonus issues must be at
least 12 months.

The Right issue is the issue of the shares which are offered to the existing
share holders. The value of the shares is paid by the share holders, but
the share holders have a right to reject the right issue and not purchase
the shares. The right issue gives an opportunity to the share holders to
acquire the shares at the face value, and as the market value is mostly
more than the face value the shareholders are benefited. It gives an
opportunity to the shareholders to reduce the aggregate value of the
shares.

3. Qualified shares: - The shares issued to the Directors are called as the
‘Qualified shares.’ The Directors of the company must posses certain
shares of the company to become eligible for their post. They can
purchase these shares form the market or form the company or even get
them transferred from the existing shareholders. The Directors of the
company must posses these shares within a period of two months from
their appointment. The Articles of Association of the company states the
number of shares to be possessed by the Director. The Schedule ‘A’ of
the Company’s Act 1956 states that the Director should hold at least one
share of the company and the nominal value of the share should not
exceed Rs.5000.

4. Sweat Equity Shares: - According to the amendment made in the

Companies Act in the year 1999 the Equity shares which are issued to the
Employees and the Directors at a discount for consideration other than
cash i.e. for providing the know-how or making available rights in the
nature of intellectual property rights or value additions is termed as Sweat
Equity shares. The Sweat equity shares can be issued by the company
only if such shares are authorized by a special resolution passed by the
company in the Annual General Meeting. This resolution should specify
the number of shares, current market price of the share, consideration
received and the class of the Directors and the Employees to whom such
sweat equity shares have to be issued. The company that is listed in the
recognized stock exchanges has to issue the shares in accordance with
the Securities Exchange Board of India’s (SEBI) rules. If the companies
 are not listed in the recognized stock exchanges, they can issue sweat
shares only in accordance with the prescribed guidelines.

Issue mechanism: -

The success of the public issue depends partly on the issue mechanisms. The methods
by which issues are made are as follows: -

 Public issue through prospectus: - It is the most common method

used by corporate enterprises to raise capital. By this method a prospectus is
issued to the public inviting them to invest in the issue of the company. The
company offers a fixed number of shares at a stated price. (in case of new
companies it is the face value of the shares and in case of the existing
companies it may some times include the face value plus the premium
amount, the companies with sound financial records can demand premium
form the market.) The public issues are generally underwritten to ensure the
success of the issue. It is a service provided by the banks, financial
institutions or brokers to eliminate the risk arising from the uncertainty of
public response. The amount of the issue which is unsubscribed is taken over
by the underwriters. They also get a commission form the company for
providing these services. The prospectus of the issue must contain the
following:

1. Name and address of the registered office of the issuing company.

2. Existing and proposed activities of the company.
3. List of the Board of Directors of the company.
4. Authorized, subscribed and proposed capital of the company to the
public.
5. Dates of opening and closing of the subscription list.
6. Names of the brokers, underwriters and others with whom the
application forms along with the prospectus can be obtained.
7. The permission obtained from the SEBI to deal in shares.

The draw back to this method is that raising capital through this method is very
expensive. The floating costs involve the underwriting expenses, brokerage and
other administrative expenses like the printing charges of the prospectus,
publicity charges, accountancy and bank charges, legal charges, stamp duty,
listing fees, registration charges, filling of documents, mortgage deed registration
etc. It is useful for large issues.
 Private placement of shares: - Another method of floating the securities in
the capital market is the placement method. This method is defined as,’ the
sale by an issue house or brokers to their own clients of securities which have
been previously purchased or subscribed.’ The placing of the securities
which are unquoted is known as private placing of the shares. To promote
this method each issue house has its own list of large private and institutional
investors who are ready to float the securities. The private placement is done
in two stages, the first stage is to acquire the shares by the issuing house and
the second stage is to make it available to the investor clients. While doing
this transaction the issuing house usually places the securities at a higher
price than the price they pay to the company and difference is their
remuneration. Alternately they may make these arrangements for fees in
return and merely act as an agent and not the principal. The placing letter and
other documents constitute the prospectus/ the offer document and the
information concerning the issue which has to be published. The main
advantage of issue through private placement is that

1. Formal underwriting of the issue is not necessary.

2. The company can select the main share holders.
3. Usually the cost of the public issue is 15% to 20% of the whole size of
the issue, which a costly affair for the company and through private
placing of the shares this cost can be minimized as this method is
comparatively cheaper.
4. This method is suitable in case of small issues.

The basic disadvantage is from the point of view of distribution of the

securities are that the securities are offered to a selected group of investors
which may lead to concentration of shares in few hands and create an
artificial scarcity of shares when these shares are listed.

 Tender building method: -This method is similar to the Public issue method.
The essence of this method lies in the pricing of the issue as the pricing is left
to the investors of the issue. Under this method the issuing company
incorporates all the details of the issue proposal in the offer document on the
lines of the Public issue method; this proposal also contains the reserve or
the minimum price. The investors are required to quote the number of
securities and the price at which they wish to acquire the shares.

 Offer for sale: - This is another method of issuing the securities in the
market. Under this method the issuing company dose not offer its shares
directly to the public however, it offer through the intermediary i.e. a merchant
 banker or issue houses. These promoters offer the shares to the public,
therefore, in the offer for sale the issue is carried out in two stages, the first
stage is of selling the shares by the company to the issuing house at a fixed
price, and the second stage is the selling of the shares by the issuing house
to the general public at a price which is higher than the price quoted by the
company, the difference is the commission of the issuing house. Underwriter
is appointed as the issue is largely in the hands of the issue houses. The
basic advantage of this method is that the issuing company is saved of the
cost and the trouble of selling the shares to the public.

Purchase / buy-back of own securities

According to the amendment made in the Companies Act 1956 in the year
2000 the company can purchase or buy-back its own shares or other
securities as per the following conditions: -

 The buy back is made through the free reserves of the company, or
out of the share premium, provided that the buy back is not made out
of the proceeds of the earlier issue of the same kind of shares or other
specifies securities.

 For conducting a buy back the company should be authorized by the

Articles of Association of the company and also by passing a special
resolution in the Annual General Meeting of the company.

 The buy back is authorized only if the following conditions are fulfilled
– the total buy back is less than 10% of the total paid-up equity capital
and free reserves of the company, the buy back has to be authorized
by the Board by passing a resolution in the meeting of the company,
the ratio of the debt owed by the company is not more than twice the
capital and reserves of the company.

 The procedure for buy back should be completed with 12 months of

passing the resolution in the Annual General Meeting of the company.

 When the company buy backs its own securities, it has to destroy the
securities so bought back with seven days of the last date of the
completion of the buy back.
  The details of the securities so bought back should be filed to the
Registrar of the companies and the Securities and exchange board of
India within 30 days of the completion of the procedure of the buy
back by the company. In case of default of this provision in time the
company or the officer in charge shall be punishable with a term of
imprisonment for a term extending to 2 years or with a fine extending
to Rs.50000 or with both.

 When the company buy backs the shares the amount equal to the
nominal value of the shares must be transferred to the Capital
Redemption Reserve and these details of the transfer must be
disclosed in the Balance sheet of the company.

DEBENTURES

Debentures are documents issue by the company as an evidence of the debt due
from the company with or without charge on the assets of the company. The debentures
or the bonds represent the creditorship securities, so the holders become the long term
creditors of the company. The debenture certificates are the certificates issued by the
company under the seal of the company which acknowledge debt due by it to its
holders. According to the companies act the term debenture includes the stocks, bonds
or any other securities whether constituting a charge on the assets of the company or
not but these become the creditors of the company are called the debenture holders.

It is a borrowed source of long term capital. The debenture holders do not get the
ownership rights in the company however; these get the identity of a creditor of the
company. The debentures are the fixed income bearing investments. The company
promises the debenture holders the stipulated amount of interest and also the payment
of the principal at the end of the maturity period. The rate of the interest and the maturity
period is specified in the offer document.

Features of debentures: -

1. The investors who invest in the debentures of the company are not the owners of
the company. They are the creditors of the company, so the company borrows
the money from them.

2. The debenture holders get the status of a creditor in the company and these do
not enjoy the voting rights in the company.

3. The capital gathered by the company by way of debentures is a long term source
of finance and not a permanent source as the debentures have a maturity date
 and the company has to pay to the debenture holders at the end of the stipulated
period stated by the company.

4. For facilitating the repayment before maturity a sinking fund is maintained by the
company or the trustees of the debentures. They purchase the debentures and
redeem them in an acceptable manner. The sinking fund is the cash put aside
periodically for the retirement of the debentures to help the company and
reducing the burden during the temporary financial crisis.

5. Returns paid by the company to the debenture holders are in form of interest.
The rates of interest are predetermined, and freely decided by the company. The
interest is paid on the face value of the debenture even if the debenture is paid at
a premium or a discount. The interest on the debentures is payable even if the
company dose not make profits in the financial year. The debenture holders have
a priority in payment of any dividend to the share holders. Due to this the
investment in debentures becomes risky from the company’s point of view.

6. The investment in debentures from the investor point of view is less risky, as it is
an assured source of investment and in the event of the non-payment of interest
or the principal amount the debenture holders can interfere in the operations of
the company by taking legal actions.

7. In financial terms the debentures prove to be a cheaper source of funds for the
company as the rate of interest in pre-determined and the amount of interest is
deductible from the taxable income of the company therefore, the cost of capital
of debentures in less than the share capital of the company.

8. The interest received by the debenture holders is taxable in the hands of the
holder.

9. The debenture holders have a priority to claim the amount of the principal before
any of the share holders at the time of liquidation of the company.

10. The debentures are generally secured against the immovable property of the
company. If the company fails to pay interest or principal to the debenture
holders these can sell the immovable properties against which they are secured
and clear their dues.

Attributes: -
Debentures are a long term source of investment but they have some contrasting
features as compared to equities: -

 With an intention of protecting the interest of the debenture holders certain

amendments were made in the Companies Act 1956 recently. When a
debenture is sold to the investing public a trustee is appointed by the company
through an Indenture or a trust deed. The trustee is usually a financial
institute, bank or an insurance company. These trustees are primarily
responsible to ensure the interest of the debenture holders. The trust deed
provides specific information such as the description of debentures, rights of
the debenture holders, rights of the issuing company and the responsibilities
of a trustee. The trustee is responsible to ensure that the company fulfills all its
contractual obligations.

 The trustees have to ensure that the assets of the company and of the
guarantors are sufficient to discharge the principal amount at all the times. If
the amount of the assets are found to be less or insufficient then a petition can
be filed with the Company law board.

 They have to ensure that the prospectus or the letter of offer must not contain
any matters which are inconsistent with the terms of the debentures or with
the trust deed. It has also to ensure that the company dose not make any
breach in the provisions of the trust deed and to take steps against the
company if there is any breach of the provisions of the trust deed or in terms
of the issue of the debentures. The trustees can also call a meeting of the
debenture holders whenever required.

 The trust deed is issued in a stipulated period and in a prescribed format for
securing the issue of the debentures. This trust deed has to be made available
for inspection for any of the members and any of the debenture holder, they
can also take copies of the same on payment of the prescribed fees. If the
trust deed is not made available to the members or the debenture holder, then
the company and every responsible officer shall be punishable with a fine
which may extend to Rs.500 per day during which the offence is made.

 The debentures carry a fixed coupon rate of interest, the payment of which is
legally enforceable. The debenture interest is tax deductible and is payable
annually, half yearly or even quarterly. Some public sector undertakings issue
tax free bonds, the income from which is exempted from tax in the hands of
the investors. The company is free to choose the coupon rate fixed or floating,
it is related to the benchmarks and the credit ratings of the debentures.
  The debentures have a maturity period. It indicated the period of time for the
redemption of the debentures at a par value. The company can decide the
period for the non-convertible debentures. The company accomplishes the
redemption of the debentures with help of DRR or the sinking fund and the call
and the put provision.

 The company issuing the debentures has to maintain a reserve for the
redemption of the debentures in which every year adequate amount is
credited until the debentures are redeemed. This reserve must be equal to
50% of the amount of the issue, before the commencement of the redemption.

 The debentures can be issued with a call and a put option. The call option
gives the issuing company liberty to redeem the debentures earlier than the
redemption date at a pre-determined price or a strike price, if the price is
higher than the par value it is called as the call premium. If the company does
not exercise the option then the debentures continue. The put option gives the
investors the right to demand back the money earlier than the redemption date
at a pre-determined price. The call option is beneficial to the company as it
can redeem the debentures which cannot be put to a profitable use when the
company has surplus funds. While the put option is beneficial to the investor
since he can get back the money if he feels that he is not been benefited from
the investments or the same funds could be invested in a more profitable
investment.

 The debentures are compulsorily credit rated by one or more of the four credit
rating agencies namely CRISIL, ICRA, CARE and FITCH India.

Types of Debentures
 TYPES OF DEBENTURES

SECURITY REPAYMENT CONVERSION TRANSFERABILITY

SECURED REDEEMABLE CONVERTIBLE BEARER

UN-SECURED IRR-REDEEMABLE NON- REGISTERED

CONVERTIBLE

The types of debentures are divided under four different categories and each
category has two different types of debentures.

1. SECURED: - The types of debentures which are categorized according

to the charge the debentures have on the assets of the company are
included under this heading.

 Secured debentures: - The debentures which have a charge on

the assets of the company are called as secured debentures. The
charge on the assets is of two types, namely fixed charge and
floating charge. The fixed charge means some fixed assets like
land, plant, machinery or building etc. are offered as securities. It
means that no other person can sell these assets and ascertain
claim on these assets, they are used as an exclusively cover for the
debenture holders. at the time of liquidation of the company these
assets are sold and the debenture holders are paid. The floating
charge means that the debenture holders have an overall charge
on the assets of the company and no specific assets are pledged.
The charge is generally on the total assets of the company.

 Un-secured debentures: - The debentures which do not have a

charge on the assets of the company are called un-secured
 debentures. Such debentures holders have a status of a normal
unsecured creditor of the company. For securing the payment of
the interest and the repayment of the principal amount no assets
are pledged however, the payment purely depends on the solvency
of the company.

2. The types of debentures which are categorized according to the

repayment of the principal are included under this heading.

 Redeemable debentures: - Redemption means repayment of the

principal amount on the date of maturity. These types of debentures
have a fixed maturity period and after the expiry date these are
repayable.

 Irredeemable debentures: - The debentures which do not have a

fixed maturity date and are generally not refunded in the life time of
the company are called as Irredeemable debentures or ‘Perpetual
debentures.’ These debentures are a sort of permanent capital to
the company. According to the call and the put option the company
has the right to redeem the debentures only after giving an advance
intimation to the debenture holders, and the debenture holders
have a right to withdraw the amount from the company.

3. The types of debentures which are categorized according to the

convertibility are included under this heading.

 Convertible debentures: - Convertibility means getting the

debentures converted into shares at the end of the maturity period.
The debentures which can be converted fully or partly are termed
as convertible debentures. The Articles of Association lays down
the terms and conditions for the issue of the fully or partly
converted debentures. According to these terms and conditions the
debentures are fully or partly converted into shares at the maturity
date. Before issuing such type of debentures the company has to
take a prior approval of the Central Govt. and also pass a special
resolution in the Annual General Meeting. Such debentures
automatically get converted into shares or can be exercised and
then get converted. These conversions are advantageous to both
the debenture holders as well as the company.
  Non-convertible debentures: - The normal redeemable
debentures which are not converted into shares are to be repaid
after the date of maturity is called as non-convertible debentures.

4. The types of debentures which are categorized according to its nature of

transferability are included under this category.

 Bearer: - These debentures are like negotiable instruments. The

debenture document dose not posses any name or address of the
holder. The company also dose not have the name and address of
the holder. The person who posses the debenture document is the
holder of the debenture and is authorized to get the payment of the
interest and the principle on the date of maturity. The interest
coupons are attached to the debenture instrument. The bearers can
en-cash the amount of interest on the due-dates. The bearer gets
the payment of the principal amount on the maturity date.

 Registered: - The debentures who posses a name and address on

the debenture document and is also registered in the same way
with the company are called as registered debentures. These types
of debentures are safer and these cannot be treated as negotiable
instruments. These debentures can be transferred from one person
to another through board resolution and by a regular transfer
instrument. After the transfer process is over the name and address
in the companies register as well as on the instrument is changed.
These debenture holders get interest through the interest warrants.

Advantages of Debentures: -

To the company

1. No dilution of ownership: - By issuing the debentures the controlling

position of the existing shareholders dose not get diluted or affected as
the debentures do not have any voting rights and the debenture holders
are not the owners of the company these are the creditors of the
company. Thus debentures provide long term finance with out dilution of
the ownership.

2. Economical option: - The cost associated with the debentures is

comparatively less than the cost associated with the equity shares as the
 interest on debentures is a deductible expense for taxation. It is
economical for the company to issue debentures.

3. Limited liability: - The interest rates of the debentures are fixed and are
pre-decided. Thus these do not participate in the extraordinary profits of
the company and the liability can be provided for. The debentures are to
be paid off at the maturity period therefore, the future liability can be
reduced.

4. Debentures provide funds to the company for a specific period hence the
company can appropriately adjust its financial plan to suit its
requirements.

5. The company might have borrowed various small amount of debts of

short duration which may be costly and burdensome to the company
therefore, all these can be converted into a single issue of debentures
which prove to be less costly.

6. Debentures enable the company to take advantage of trading on equity

and thus pay to the equity share holder dividends at a higher rate higher
than the overall return on investment.

7. During inflationary period the real value of money reduces, the amount of
interest and the principal to be paid remains the same and this is
advantageous to the company.

To the Investors

8. Debentures are more suitable for investors who are cautious and
conservative. The investors who particularly prefer a stable rate of return
from the investment with little or no risk then debentures are ideal
investments for those.

Disadvantages of debentures: -
 1. By issuing the debentures, the company takes two types of risks, one to
pay the interest at a fixed rate, irrespective of the non-availability of
profits and second the repayment of the principal amount at the pre-
decided time. Both these would become risky for the company which has
unstable earnings as the demand for its products is highly unstable.

2. Raising funds through debentures is risky as it is obligatory on the part of

the company to pay the interest and repay the principal and in case of
failure of the company, the debenture holders may resort the extreme
remedy of filling the petition for winding up the company.

3. Financing the capital structure through debentures is risky. Debentures

are particularly not suited to those companies whose earnings fluctuate
considerably.

4. At the maturity of the debentures the company has to pay out, this
involves a substantial cash outflow. This may create a cash crunch in the
company if the payments are not been planned and provided for.

5. Every additional issue of debentures becomes more risky and costly on

account of higher expectations of the debenture holders. If their stake in
the capital structure increases they may demand higher rate of interest
besides power to have some say in the management of the company.

LOAN FINANCING

The financial needs of an enterprise may be met by taking loans. The loans
indicate liabilities accepted by the enterprise for satisfying the short term and long term
requirements. Banks (nationalized, cooperative, rural etc.) and financial institutions have
the authority to grant loans.

Short term loans: -

The finance required for working capital i.e. the daily routine requirements is
satisfied by the short term loans or trade credits.

I. Trade credits: - It is form of short term financing common to all types of business
firms. It is the largest source of short term funds. Under this system the buyers are
not required to pay for the goods on delivery however, these are allowed a short
term credit period before the payment is made due. These credits are in form of an
open account credit arrangement and by acceptance credit arrangement. In case
of a open account credit arrangement the buyer dose not sign a formal debt
instrument as an evidence of the amount due by him to the seller. While in case of
the acceptance credit agreement the buyer accept the bill of exchange or a
promissory note for the amount due by him to the seller. Thus it is an agreement
by which the debt of the buyer is recognized formally. The trade credits do not
create any charge on the assets. The terms of the trade credits depend on the
reputation of the purchasing firm, financial position of the seller and the volume of
purchases made by the buyer.

Advantages of trade credit: -

 The major merit of trade credit as a source of finance is its ready

availability.

 It is available on a continuous and on a informal basis. For getting this

finance it is not necessary to make formal arrangement. Additional credits
are easily available before the expiry of the existing credit period.

 For obtaining the trade credit it is not at all necessary to create any sort of
charge against the assets of the enterprise.

 The trade credits are flexible means of finance. As the buyer does pledge
any securities however, it does not follow a strict schedule of payment as
the bank lending.

 The amount of trade credit is not restrained by law.

Disadvantages of trade credits: -

 The cost of trade credit may be very high in case all the factors are
considered. The seller of the products takes into consideration the
interest, risk and inconveniences attached with the supplying of goods on
credit. In such case the selling price of the goods is pre-decided. Many
enterprises take into consideration other sources or finance and avail cash
discount.
  Due to the availability of a liberal trade credit the firm may induce it self
into over trading, which may later prove to be disastrous for the enterprise.

Thus the enterprise must balance the advantage of trade credit as a

discretionary source of financing after considering the capacity of it.

Commercial Banks: -

The commercial banks mostly provide short term and medium term credits to the
business. These give credits in following forms: -

 Loans: - It is a kind of advance made with or without security. In case of a loan

the banker makes a lump sum payment to the borrower or credits it to the deposit
account the amount is given for a fixed period and an agreed rate of interest. The
interest is calculated on the entire amount of the loan and not on the amount of
loan which is withdrawn. The loan which is repaid in full or in part cannot be
again withdrawn till the bank again sanctions a fresh loan. The rate of interest is
lower than the cash credits or overdrafts as the maintenance of these accounts is
much less due to less frequent operation of these accounts. More to that the
bank gets interest on the full sanctioned amount. The loans given by commercial
banks can be a term loan or a demand loan. The term loan is of a medium term
which is repayable within 1 to 5 years and a long term which is repayable after a
period of 5 years. The demand loan is for a short period and is repaid on
demand.

 Cash Credits: - The cash credit is an arrangement by which the customer is

allowed to borrow money from the bank up to a certain limit. For getting a cash
credit limit sanctioned the company has to present the statement showing the
difference between the debtors + stock – creditors and this amount decided its
cash credit limit.

It is also necessary to hypothecate or pledge the commodities as security. When

the goods are hypothecated the goods are given in the possession of the banks
however, the goods actually remain at the disposal and in the godown of the
borrower. The bank is allowed to inspect the goods whenever they desire. The
borrower uses the goods and gives periodical returns to the banks.
Hypothecation is allowed only to those persons to whom the bank has full
confidence.
 In case of pledge the goods are placed in the custody of the bank and in the
bank godown. The borrower has no right to deal with the goods which are
pledged.

The advantages of cash credit are that the large commercials and large
industrial concerns get the cash credit limits sanctioned however, they need not
withdraw the whole amount, they can withdraw such amount as and when
required and interest is calculated only on the amount which is actually
withdrawn. The borrower can put back the excess amount which he finds surplus
with him. The cash credit is available whenever it is needed and the limits can be
increased according to the level of activity. To safe guard the interest of the bank
on account of unnecessary locking of funds the banks can put a interest clause
according to which the customer has to pay interest on a certain proportion of
amount say one third, one forth even though the amount is not withdrawn by the
borrower.

 Overdrafts: - A financing option provided by the commercial banks by which the

customers are allowed to overdraw on their current account with or without
security is called as the overdrafts. The temporary requirements of cash are
satisfied by this way. It is advantageous to the borrower as the interest is to be
paid only on the amount actually withdrawn. It is different from the cash credit
facility as the cash credits are used for long term use of funds while the
overdrafts are utilized for the short term needs and on a regular basis

 Bill discounting: - The banks also discount the bills for its customers. The bills
after selling the goods on credit are presented to the bank and the bank gives the
amount after deducting the amount of the discount. The bank discounts the bills
with or without security

 Term loans: - The loans made available by the banks and the financial
institutions for a longer period with an initial maturity of more than one year are
called as term loans. Mostly the financing made by way of term loans is for the
company’s capital expenditure and infrastructural changes.

Features of term loans: -

1. Term loans are granted for establishment, renovation, expansion,

modernization of the industrial unit, for meeting the requirements of the
core working capital, for retiring the bonds and redeeming the preference
shares.
2. The banks and the financial institutions granting them the loan do not
become the owners of the company. They lend funds to the company and
they become the creditors of the company.

3. The term loans are granted for a specified period these have to be repaid
in the pre-decided intervals i.e. monthly, quarterly or yearly. Generally the
loan period is from 8 years to 15 years. The initial gap after which the
repayment starts is called as the moratorium period and it depends upon
the agreement between the borrowing company and the lending bank.

4. The term loans are usually secured. The bank or the financial institution
has a fixed or a floating charge against the assets of the company. A fixed
charge the borrowing company offers the fixed assets for mortgage or
hypothecation. The lending company prefers a fixed charge. The borrower
has also to present collateral or a secondary security for getting the term
loan.

5. Returns payable by the enterprise on the term loans are in form of interest
which may be calculated on monthly, quarterly or on half yearly basis at a
pre decided rate on the outstanding balance of the term loan. The interest
on term loan is payable even if the enterprise dose not make any profits.

6. The enterprise directly negotiates with the banks or financial institutes for
the terms and conditions of the loans and for the project finance, thus the
cost of rising the finance reduces. The underwriter’s commission and
floating costs are saved.

7. While granting the term loan a formal agreement is prepared containing

the terms of the loan and the protective clauses for the benefit of the
lender.

8. Using term loan as a source of finance is a risky from the enterprise point
of view, as they have to bear a two fold risk. The interest has to be paid at
a pre-decided rate and a pre-decided time interval irrespective of the
profitability, and secondly the enterprise has to pay the principal amount in
time.
 9. The lending bank faces very less risk in case of term loans as the are the
creditors of the enterprise they can not control the affairs of the enterprise
nor they have the voting rights, but the payment of interest and the
principal is a compulsion for the borrower. However in the event of non-
payment of the interest or the principal amount they can interfere in the
operations of the enterprise by taking legal actions.

10. Term loan introduces proper financial discipline in the borrower. As he has
to forecast the cash flows with reasonable accuracy so that the payments
of the interest and the principal are made as per the agreed schedules.

11. The banks and financial institutions are interested in getting their money
back with the interest; therefore, they put certain restrictions on the
borrower. The enterprise with a weak financial status attracts more strict
norms. The restrictions are as follows: -

 The borrower has to provide full financial information by way of

periodic financial statements.
 To maintain a minimum asset balance. The borrower is not allowed
to sell any of the fixed assets without the permission of the lender.
 The enterprise is restrained from getting additional loan.
 The promoters and the directors are not allowed to sell of their
shares in the enterprise.
 The cash outflows by way of dividends, salaries, perks to
managerial staff, capital expenses are restricted.
 Loan shall be payable before maturity under specified
circumstances.
 The directors will furnish personal guarantees for the repayment of
the loan in addition to all other charges.

12. The term loans can be converted into equity shares of the company but
this has to be stated in the terms and conditions by the lender.

Repayment of the loan: -

The repayment of the loans is according to the repayment schedules which show the
interest and the principal amount separately. Usually the amount of the loan amount is
divided between the half yearly or annual installments. Due to this the interest burden
goes on reducing over years till the maturity period.
PUBLIC DEPOSITS

This is a mode of collecting finance from the public. Many companies accept deposits
for a short period from their members, directors and from the general public. The public
deposits play an important role in financing the short term requirements of the business.
The interest rates depend upon the prevailing market rates. The companies prefer the
public deposits are they are cheaper than the bank borrowings.

The rules for accepting the public deposits are as follows: -

1. To treat the deposit as a public deposit, it should not be accepted from

 Government or the persons whose deposits are guaranteed by the

government.
 Banks and financial institutions
 From any other companies
 Security deposits from employees
 Advances received against purchases or sales
 Amount received from pending allotment
 Amount in transit
 Amount received from the directors or the share holders of a private
limited company.

2. Such public deposits should be repayable on demand and their period should
be minimum of 3 months and maximum to 36 months.

3. The company cannot accept deposits more than 35% of its paid-up-capital and
free reserves.

4. Public deposits are the unsecured borrowings of the company.

5. Company can raise funds in form of public deposits which can be used for any
purpose, as the end use of the funds is not committed by the company.
 6. In the situation of credit squeeze introduced by the banks, the public deposits
play a very important role.

7. If the company decided to invite the public deposits it has to make

advertisements. Such advertisements must contain detail information of the
company, its branches, subsidies, details of the directors, dividend details,
summarized financial position of the company as in the two audited balance
sheets immediately preceding the date of advertisement, the amount of
deposits which can be raised by the company and the aggregate deposits
collected in the last year, the statement stating that the company dose not have
any over due deposits etc. and the copy of this advertisement should be signed
by the maximum directors and then sent to the Registrar of Companies
(R.O.C.) This advertisement issued shall be valid for six months.

8. If the deposits are to be collected without advertisements then the same

particulars are to be presented to the R.O.C.

9. If the new deposits or renewal of the old deposits are to be made they are to be
made only through an application form.

10. Within a period of 8 days from accepting the money, the company has to give
deposit receipts to the depositors. This receipt must contain date, name and
address, rate of interest and the maturity date.

11. A register is maintained in the company containing the details of the depositors.
It should also specify the due-date of the interest payment and the dates of
maturity.

12. If the amount is to be withdrawn by the depositor, he can withdraw the amount
only after 6 months from the date of the receipt till the date of maturity. In such
case the company has a right to deduct 1% of the interest as the processing
charges.

13. The company who accepts the deposits has to file a return to the R.O.C. in their
prescribed format containing information about all the deposits as on
31stMarch. These returns are to be made on or before 30th June each year.

Advantages of Public Deposits: -

 1. Financing through public deposits is simple without much of complicated
formalities involved. The company has simply to advertise and inform the public
that it is interested and authorized to accept the public deposits.

2. It is a less costly method of raising short term as well as medium term funds
required by the business.

3. There is no need of creating a charge against any of the assets of the company
for raising the funds through public deposits.

4. Thanks, company can take advantage of trading on equity since the rate of the
interest is low and the period for which the public deposits are accepted are
fixed.

Dis-advantages of Public Deposits: -

1. Raising the funds through Public deposits is not a reliable and definite source
as the companies enjoying good reputation in the market are able to raise
sufficient funds through public deposit however the companies not enjoying
such a reputation in the market cannot raise sufficient funds by this method.
More ever in the period of depression this source shall also dry up.

2. This mode of financing sometimes may put the company into a serious
financial problem as even a slight rumors in the market stating that the
company is not performing well may result in a rush of the public to collect the
premature payment of the deposits made by them.

3. The reliance of the companies on the public deposits is injurious to the stock
market as the supply of shares and debentures to the general public will be
affected.

INTERNAL SOURCES OF FINANCE

A new company has only the external sources of finance. But an existing company who
has created a base by generating profits can finance its needs through the internal
sources also. The prominent sources of internal finance are the retained earnings, and
depreciation. The internal financing can be defined as,’ the utilization of funds generated
from operations like manufacturing and selling to acquire new assets.’

A. Financing the needs through retained earnings: -

The retained earnings is defined as,’ the amount of profits after taxes not
paid out as dividends, which are therefore available to a company to finance
their additional assets.’ So the retained earnings form a part of the net worth
which represents the total funds belonging to the share holders. The
retained earnings are not only a method of raising finance but it also refers
to the accumulation of the profits for its developmental activities and also to
repay loans. It is also called as the internal financing or the ploughing back
of the profits. The retained earnings or the ploughed back profit is one of the
best sources of long term finance. According to the recent amendments in
the companies act a certain percentage of the profits after tax has to be
compulsorily transferred to the reserves by the company, before declaring
dividends for the year. The central government has prescribed that the
amount transferred to the reserve must not exceed 10% of the net profits
after tax.

Merits: -

 Financing through retained earnings is readily available

 The cost of raising finance like the issue cost, under writing cost is
eliminated
 There is no dilution of control when the company relies on the
retained earnings.
 It enhances the business reputation and increases the capacity of
the business to absorb the unexpected and sudden business
shocks.
 This method has been found useful to finance the expansions and
improvements in the business.
 This source is very useful as it dose not carry the fixed obligations
regarding the payments of the dividends and the interest.
 As compared to any other sources of finance this method of
financing has least cost. But it is not wholly correct that the retained
 earnings do not bear any cost, but the cost of the retained earnings
is that cost which the share holders would have earned if it had
been distributed.

Demerits

 The amount that can be raised by way of retained earnings may be

limited as most of the companies follow a stable dividend policy, so
the variability of the profit after tax is transmitted to the retained
earnings.
 The share holders may also object the regular use of the retained
earnings as it affects the shareholders income.
 Excessive use of the retained earnings continuously may result in
converting the company into a monopolistic organization.
 The retained earnings may be misused by the management to
manipulate the share values of the company in the stock exchange
and also to cover the inefficiencies of the management affairs.
 If retained earnings are continuously used as a source of finance it
is also harmful to the social interest as the individuals investing
through the capital market would loose the chance of investment.

RESERVES AND SURPLUS

Surplus is the balancing items between the stated values of the asset on the one
hand and liability plus stated capital on the other. But a careful distinction must be made
between the surplus that is accumulated from the earnings and the other sources. The
former is the part of the profits which are put aside; they are the part of the profit after
tax which is accumulated after payment of the dividend. The later category is usually
called the capital surplus, which arises from the payment of the stocks in excess to the
stated value, donated funds, or from the unrealized write-up to the value of the stock.
Thus the surplus arising form the other sources of surplus is the balance arising
between the value of the assets on one side and liabilities and the capital on the other.
This surplus is legally allowed as a source of dividend but a sound practice normally
prohibits this practice. The dividends are paid only out of the accumulated earnings.

There are three classes of reserves which are commonly accepted, like
  The asset valuation reserve: - It is an offsetting account for reducing the
value of the asset. Typical reserves of those are the depreciation reserve,
inventory decline reserve, doubtful accounts receivable etc. This reserve is the
value which is to be used to reduce the asset, many times this reserve is
adjusted by reducing the assets and then shown in the Balance sheet the and
so it cannot be utilized for the payment of the dividends.
The reserves which arise out of the charges against the revenue expenses are
classified as the asset reserves. These reserves are for those expenses which
are still not charges such as the losses due to fir etc.

 The liability reserve: - It is the reserve which is being created for the
liabilities to be paid out in the near future. Commonly these reserves consist of
the reserves made for the payment of the taxes, employee benefits, contingent
liabilities etc. But these are not the reserves in the company, they are just the
estimations of the expenses which are shown in the balance sheet till the actual
figures of the expenses are known and then they are written off. But the
accountants demand that the term reserve should be abolished and these
estimations should be referred as the deferred liability. But the contingent
liability can be handled in two ways. If the liability can be estimated then
amount can be shown as a contingent liability but if the amount cannot be
estimated and is merely used to reduce the earned surplus then it is properly
shown as a net worth reserve and not a liability reserve.

 The net worth or the surplus: - These reserves are used to hedge the
errors in the income determination, uncertainties in the business so that the
business has not to pay out all the profits, to reduce the surplus so that the
pressure form the shareholders for higher dividend is reduced, to withheld the
earnings for the repayment of the debt or for the financing of the expansions of
the business.

BONUS SHARES

The bonus shares are defined as,’ an extra dividend to the share holders in a
company from the surplus profits.’ This is an issue of the shares of a company, by
capitalizing the part of the company’s reserves. The decision to issue of bonus shares is
made with a motive of bringing down the share prices in the absolute terms and to
ensure a continuous investor interest. Following the bonus issue the number of the total
shares increases but the proportionate ownership of the shareholders dose not change.
While issuing the bonus shares certain rules have to be followed that the bonus shares
can be issues only out of the free reserves created out of the genuine profits or by the
share premium collected in cash, and the residual reserves must be 40% of the
increased paid-up capital.

The effect of the bonus shares is shown in the table below

EFFECT OF THE BONUS SHARES

 EQUITY PORTION BEFORE THE BONUS ISSUE

Equity share capital (30000 shares of Rs.100 each) Rs.30,00,000

Share premium (@ Rs.25 per share)

7,50,000

Retained earnings 62,50,000

Total equity 100,00,000

 EQUITY PORTION AFTER THE, BONUS ISSUE ( 1 : 2 )

Equity share capital (45000 shares of Rs.100 each) Rs.45,00,000

Share premium (7,50,000 – 3,75,000 + 3,75,000)

7,50,000

Retained earnings (Rs.62,50,000 - 15000 shares * Rs.100) 47,50,000

Total equity 100,00,000

 From the above table it is seen that the bonus issue reduces the share
premium, retained earnings and correspondingly increases the paid-up equity
capital as well as the share premium.

The dividends paid to the share holders in form of shares are termed as bonus
shares. The bonus can also be defined as,’ the shares allotted by the
capitalization of the reserves or the surplus of the corporate enterprise.’ When
the company’s profits are converted into shares it is termed as the capitalization
of the profits. Such shares are issued to the share holders of the company in
the proportion to their holdings of the equity shares in the company. The bonus
share issue dose not affect the total capital structure of the company, but it is
simply a capitalization of the portion of the shareholders equity which is
represented by the reserves and surplus.

Illustration: -

The capital structure of a limited company is as follows: -

Equity share capital (Rs.10 per share) Rs.4,00,000

Share premium 6,00,000

Reserves and surplus 3,00,000

Total net worth 13,00,000

The company issues bonus shares to the existing share holders in ratio (1: 10)

At a market price of Rs.15 per share

You are required to calculate: -

I. The new capital structure of the company

II. Earning per share of both before and after the bonus issue if the net
earnings of the company are at Rs.44,000
Solution: -

The total number of equity shares are (4, 00,000/100) 40000

The bonus issue is of (1: 10) 4000 shares

The price per share is of Rs.15 i.e. Rs.5 per share as premium

I. The new capital structure of the limited company

Equity share capital (Rs.10 per share * 44000) Rs.4, 40,000

Share premium (6, 00,000 – 20,000 + 20,000) 6, 00,000

Reserves and surplus (3, 00,000 – 40,000) 2, 60,000

Total net worth 130, 00,000

II. Calculation of Earning per share

Earning per share before the bonus shares were issued

Net earnings Rs.44, 000

Number of equity shares 40,000

Earning per share Rs.1.10

 Earning per share after the bonus shares were issued

Net earnings Rs.44, 000

Number of equity shares 44,000

Earning per share Rs.1.00

Advantages of issuing bonus shares: -

Advantages to the company: -

1. The company can retain the cash resources for the future expansion,
diversifications plans and to satisfy the future needs of the company and
as well satisfy the share holders by satisfying their desire to receive
dividend.

2. The bonus issue reduces the E.P.S. and keeps it at a reasonable level
without affecting the interest of the share holders.

3. The issue of the bonus shares reduces the market price of the share and
brings the price in the reach of the ordinary investors, thus increasing the
marketability of the shares.

Advantages to the investors

4. The receipt of the dividends in form of shares is not taxed as compared to

those dividends which are received in cash are included in the income and
are taxed under usual income tax rates. The share holders can sell the
bonus shares to satisfy their need for cash. The profit made from the sell
of such shares will be deemed as capital gain and will subject to lower rate
of income tax.
 5. The company issues bonus shares only when it has sufficient reserves
and surplus. The bonus issue is generally an indication of higher future
profits; this is because the company shall declare a bonus issue only
when it expects the earnings to increase. In absence of such an increase
in the earnings the earning per share shall get more diluted which is not
desirable at all.

6. Due to the bonus issue the dividends received by the investor increases,
so a bonus issue increases the future dividend earnings of the investors.

7. The bonus issue is always invited with a positive response from the
market. The market value of the shares of the company may rise in the
stock exchange in place of falling. This is advantageous to the investors.

Thus bonus shares are a good internal source of finance. It not only helps in
capitalization of the reserves of the company but also increases the market value
of the share and satisfies the share holders. Though it increases the future
liability of the company it is very useful source of internal finance.

Depreciation

Depreciation means the continuous, gradual and permanent reduction in the

value of the fixed asset brought about by factors like wear and tear, erosion,
rot or rust, obsolescence, depletion or passage of time. Depreciation is
defined by Carter as – ‘Depreciation is the gradual and permanent decrease
in the value of an asset from any cause whatsoever.’ The main three
objectives of charging depreciation are

 To ascertain the true profit or loss of the business every year.

 To show the true value of the asset in the balance sheet.
 To provide for the replacement of the asset in a period of time.

There are eight different methods of depreciation. But the most commonly
used method is the Straight line method where the depreciation is
 calculated on the original value of the asset and it remains constant through
out the life of the asset.

B. Depreciation as a source of finance: -

There is a lot of controversy among the accountants and business

executives regarding the treatment of depreciation as a source of funds.
There are two view points regarding the treatment of depreciation.

 The people who oppose the treatment of depreciation as a source

of finance argue that the funds can be generated in the business
only by way of operating profits and not by making the provisions
for the depreciation. The business executives feel that, if the
depreciation would have been a source of finance for the company
then the company would have improved upon the position by
increasing the depreciation at its will. They further argue that the
depreciation is a non cash expense and so it dose not effect the
working capital of the company thus it cannot be regarded as a
source of finance.

 The accountants support the view point that the depreciation can
be regarded as a source of finance for the company. Depreciation
being a non-cash expense dose not represent any cash outlay, but
is used to reduce the amount of the fixed assets and also used to
adjust the amount net profit, and in turn adjust the taxes for the
company. So depreciation can be considered as a source of
finance. Thus the accountants regard depreciation as a source of
finance due to the following reason: -

CASE I CASE II

Rs. Rs.

Income before depreciation 1,50,000 1,50,000

Depreciation provided ------ 30,000

Taxable income 1,50,000 1,20,000

 Income tax at 50% 75,000 60,000

Net income after tax 75,000 60,000

Add non-cash expense ------ 30,000

Net flow of funds after Tax 75,000 90,000

In the above given information, in case I the asset has not being purchased but
it has been rented or leased so the depreciation is not been charged on it. But
in case II as the asset is owned the depreciation is charged. The income before
depreciation is assumed to be the same. Due to the deduction of depreciation
the taxable income of case II is lesser than case I. Thus the taxes paid are also
lesser than case I. The effect of depreciation can be seen on the net flow of
funds after tax, as the amount of depreciation which is a non-cash expense is
added back to get the true flow of funds from operation. Thus it is said that the
true funds from depreciation is the opportunity saving of cash outflow through
taxation.